CORRECTED TRANSCRIPT OF ORAL EVIDENCE To be published as HC 606-xvi

HOUSE OF COMMONS

HOUSE OF LORDS

ORAL EVIDENCE

TAKEN BEFORE THE

PARLIAMENTARY COMMISSION ON BANKING STANDARDS

BANKING STANDARDS

MONDAY 3 DECEMBER 2012

SIR JAMES CROSBY

ANDY HORNBY

Evidence heard in Public

Questions 1226 - 1526

USE OF THE TRANSCRIPT

1.    

This is a corrected transcript of evidence taken in public and reported to the House. The transcript has been placed on the internet on the authority of the Committee, and copies have been made available by the Vote Office for the use of Members and others.

2.

The transcript is an approved formal record of these proceedings. It will be printed in due course.

Oral Evidence

Taken before the Parliamentary Commission on Banking Standards

on Monday 3 December 2012

Members present:

Mr Andrew Tyrie (Chair)

The Lord Bishop of Durham

Mark Garnier

Baroness Kramer

Lord Lawson of Blaby

Mr Andrew Love

Mr Pat McFadden

Lord McFall of Alcluith

Lord Turnbull

Counsel: Rory Phillips QC, David Quest

Examination of Witness

Witness: Sir James Crosby, Chief Executive, HBOS, 2001 to 2005, examined.

Q1226 Chair: Good afternoon, Sir James. Thank you very much for coming to give evidence to us this afternoon. The Commission is looking at HBOS not least because it is the big bank failure that has not yet been addressed by an FSA report, and also because everybody was extremely badly hit. The taxpayer was in for £20 billion-a huge sum, millions of pensioners were hit and 3 million Halifax shareholders lost virtually everything as well. This really was a catastrophe. You were not called to give evidence before the Treasury Select Committee in 2009, but the time has come when we, and Parliament, should go through this territory with you. I should remind you that you are not on oath; we are using counsel, but you are not on oath. We expect candour and brief, clear and thorough replies, if possible.

I have just described a terrible catastrophe, and Lord Stevenson and Andy Hornby were also part of that. They have apologised-have you?

Sir James Crosby: I have not had that opportunity; I would like to take it now. As you know, I stood down from the role almost three years before HBOS was taken over by Lloyds, but none the less, I was horrified and deeply upset by what happened. It was hugely distressing in every sense to see the impact on shareholders and former colleagues, and also the consequences for taxpayers. I am very sorry for what happened at the bank.

Q1227 Chair: What exactly are you apologising for? For the mistakes of the bank, for which you were partly responsible?

Sir James Crosby: I am apologising for the fact that I played a major part in building a business that subsequently failed. I was not there for the last few years, but I think it would be wrong for me to dissociate myself from what happened in the end.

Q1228 Chair: So you do associate yourself with it.

Sir James Crosby: I think it would be wrong not to.

Q1229 Chair: Your total remuneration over the five years you were there was nearly £8 million, excluding your pension. Your pension is, I think, £572,000 a year indexed. Did you volunteer to waive any of those entitlements when the bank failed?

Sir James Crosby: No, I didn’t.

Q1230 Chair: Why not?

Sir James Crosby: Because I lost money, in the sense that I still had long-term incentives that were sitting there. I lost money, as I would expect to do. For most of those incentives, the money you have talked about was either salary or incentives that had been earned over a substantial number of years.

Q1231 Chair: You do understand, don’t you, that the public will accept that firms fail and that people make mistakes, but they do not understand or accept that people should profit from that? Do you grasp that the public think you have profited from your time with HBOS and you have not shown any inclination to waive any of that reward, even though you have just apologised for the fact that you are partly responsible for the failure?

Sir James Crosby: Yes, I do understand that.

Q1232 Chair: You do know that Fred Goodwin, Dennis Stevenson and Andy Hornby all waived part of their remuneration?

Sir James Crosby: I understand that was associated with termination. I did leave a few years earlier, and I did not take any notice pay or anything when I left, or any termination terms.

Q1233 Chair: It was not only termination in Fred Goodwin’s case; for example, he waived half his pension. You mentioned a moment ago that you had potential remuneration benefits from the long-term incentive plan-the LTIP. Did you sell any of the shares in it that you had acquired up to 2006 between 2006 and the failure of the company?

Sir James Crosby: I believe I did.

Q1234 Chair: How much?

Sir James Crosby: Probably two thirds. I can’t remember exactly.

Q1235 Chair: So you got out before the crash.

Sir James Crosby: In effect, yes, but not knowingly. It was just because I was, essentially, balancing my portfolio of assets some time after I had left, and it did not make good sense to have that concentration.

Q1236 Chair: You can understand that when the public hear you say, "Well, I was balancing my portfolio of assets," they are not going to be very impressed. You are talking about selling two thirds of the holdings that you had, at a time when the messages were getting increasingly strident that there were serious problems with the company that you had just left, and you were busy bailing out of it.

Sir James Crosby: I am not sure that-well, I certainly did not see it that way at the time. I did not believe that that was what people were saying, and it was certainly no part of my motivation.

Q1237 Chair: Do you not think it is reasonable for people to say that now?

Sir James Crosby: I can see why people would think that, but it certainly was not any part of my motivation or my thinking.

Q1238 Rory Phillips: Sir James, can we just start by getting the chronology right and talking a little bit about your background? First, I think you are an actuary by training. Is that right?

Sir James Crosby: Yes.

Q1239 Rory Phillips: And in terms of the two sides of HBOS, you came from Halifax. Is that right?

Sir James Crosby: Yes.

Q1240 Rory Phillips: You joined Halifax in 1994 as managing director of Halifax Life.

Sir James Crosby: Yes.

Q1241 Rory Phillips: And you became chief executive in 1999. Is that right?

Sir James Crosby: Yes.

Q1242 Rory Phillips: The same year as Lord Stevenson became chairman.

Sir James Crosby: Yes.

Q1243 Rory Phillips: Later in that year, you recruited Mr Hornby from Asda to become the chief executive of retail for Halifax.

Sir James Crosby: Yes. I believe it was later that year or the year afterwards; I am not sure.

Q1244 Rory Phillips: Thank you. On the merger with Bank of Scotland, you became the chief executive, Lord Stevenson became the chairman and Mr Hornby became the chief executive of retail for HBOS. Is that right?

Sir James Crosby: Yes.

Q1245 Rory Phillips: And of the Halifax senior executives, Mr Ellis became the finance director as well?

Sir James Crosby: Yes.

Q1246 Rory Phillips: So in terms of the Halifax presence, it was a strong presence on the board from the moment of the merger.

Sir James Crosby: Yes.

Q1247 Rory Phillips: In terms of non-retail business, that went to Bank of Scotland executives, didn’t it-Mr Matthew, Mr Mitchell and McQueen at the treasury?

Sir James Crosby: Yes.

Q1248 Rory Phillips: You remained in your post until your resignation in 2006. Is that right?

Sir James Crosby: Yes, I resigned in early January 2006.

Q1249 Rory Phillips: As I understand it, you resigned in early January, but it was effective in July that year. Is that correct?

Sir James Crosby: Yes.

Q1250 Rory Phillips: Can we look, please, at your statement, which is at tab C1? When you say in the last section of section 1, on the first page of C1, "I resigned as CEO at the beginning of 2006", in fact, it was effective at the end of June. Is that right?

Sir James Crosby: Yes, indeed.

Q1251 Rory Phillips: Thank you. Again, when you say in the introductory paragraphs to your statement that you are restricting yourself to observations to your own experience of HBOS, "substantially the years 2002 to 2005 inclusive", in fact, you were chief executive for another six months of 2006.

Sir James Crosby: Yes.

Q1252 Rory Phillips: Can I ask you, please, to look at F1, which is the final notice issued by the FSA about the bank, where we will see why this is a significant six months? If you look at the very first page of this document, in paragraph 1.1, you will see that the FSA defines the relevant period as being from January 2006 to December 2008. Do you see that?

Sir James Crosby: Yes.

Q1253 Rory Phillips: Of that period, there were two chief executives at HBOS, weren’t there-you first, and then Mr Hornby?

Sir James Crosby: Yes.

Q1254 Rory Phillips: Thank you. Now, so far as that is concerned, having seen what the FSA regarded as the relevant period, can we turn back, please, to your statement and paragraph 2 on the first page, headed, "Growth of the business"? You say, "The FSA’s Final Notice was based on what I presume was a detailed review of the period 2006 to 2008, a period substantially after I’d left." Well, that cannot be right, can it, in relation to the first six months of 2006?

Sir James Crosby: No, that was my reference to the fact I was only there for a short period.

Rory Phillips: But you were-

Sir James Crosby: Can I just be clear about one thing? The record will show that once I had resigned, I did in practice hand over day-to-day executive responsibility to my successor, and we made that clear to the City and everything else. I am not denying in any shape that I was technically chief executive until June; I am just saying that in practice, that is what happened.

Q1255 Rory Phillips: Mr Hornby has told the Commission in terms that he became chief executive in August 2006. You are not suggesting, are you, that there was some form of interregnum.

Sir James Crosby: Not at all. I am just trying to be absolutely candid with you as to why I wrote the word "substantially". It is no more and no less than that.

Rory Phillips: The importance of this is seen when you look at the FSA’s notice. If we go back to F1 on page 17, you will see that one of the periods criticised is at the top of that page; the heading is "The substantial expansion of the business between January 2006 and March 2008." So these trenchant criticisms in the notice relate in part to a period when you were chief executive. Is that right?

Sir James Crosby: Yes.

Q1256 Rory Phillips: Thank you. Now, so far as that is concerned, and the purpose of this afternoon, can I say straightaway that the thrust of what I am going to be suggesting to you is that the seeds for what went wrong at HBOS were sown during your time as chief executive. Do you understand the point I am making?

Sir James Crosby: Yes.

Q1257 Rory Phillips: The plans and the strategy that you developed straight after the merger were directly responsible for the eventual disaster, which the Chairman has explained, in 2008. That is the suggestion I am making. Do you understand it?

Sir James Crosby: Yes.

Q1258 Rory Phillips: Before we get to the detail of that, can I ask you about the other end of the period? The Commission has now received evidence from former executives at HBOS to the effect that from about the middle of 2007, when the markets began to go horribly wrong, there was really nothing very much that could be done to rescue the situation in the company. Looking at Mr Hornby’s take on this, can you go please to E1 in the file, which is where we find the evidence he gave to the Treasury Select Committee in 2009? These pages have two columns, and I am looking at the left column at the bottom, question 1695 from Mr Mann. The page number at the top left is 228.

At that session, Mr Hornby was asked about personal culpability, and said, "I have already said on behalf of the Board we accept full responsibility and have apologised for the events that have taken place, so please do not in any way suggest that I am trying to avoid personal responsibility." He then said, "I have been CEO for just over two years and it is clear in that time within eight to nine months of taking over as Chief Executive I was then faced with the collapse of wholesale markets." On that chronology, again we are looking at a period of collapse in the wholesale markets in mid-2007. Do you see the evidence he was giving there?

Sir James Crosby: Yes.

Q1259 Rory Phillips: If that is right, it means, does it not, that in the entire period from the merger to the collapse of the wholesale markets that Mr Hornby described to the Committee, you were in charge of the bank for by far the majority of that period? Is that correct?

Sir James Crosby: Yes.

Q1260 Rory Phillips: Thank you. Now the other thing that Mr Hornby said during his evidence, and I would like your reaction to this please, is slightly further on at evidence 236 at the top left of the right column about halfway down. He was asked a question at 1776 by Mr Mudie-do you have that?

Sir James Crosby: Yes.

Q1261 Rory Phillips: He was asked effectively whether the bank was using a flawed model. Do you see that? The evidence says, "You ran not exactly the same sequence but a flawed model. You ran something that when the market conditions changed your business is in a very bad way and you are an ex-chief executive officer", to which he responded, "Yes. It actually goes back many, many years in that the former Bank of Scotland business was largely reliant on wholesale funding." Do you accept that in trying to see what went wrong with this bank, one has to go back, as Mr Hornby suggested to the Committee, many, many years?

Sir James Crosby: I agree with his observation that the Bank of Scotland corporate business was, even within HBOS, very much a natural continuation of the business that existed prior to merger. It was the heart and the core of the Bank of Scotland business, and pretty well all its lending activities were those that it had been carrying out for a long period in that context.

Q1262 Rory Phillips: But it was able to do so after the merger on a much bigger scale, was it not, because of the much bigger organisation?

Sir James Crosby: Yes. That was part of the rationale for the merger.

Q1263 Rory Phillips: Can I then turn to the policies-the plans-that you put in place as chief executive after the merger? I want to start by looking at the business plan, which is at G3. By way of a preliminary question, after the merger you embarked on a rapid programme of growth, didn’t you?

Sir James Crosby: Sorry. The document has just fallen apart for a moment.

Q1264 Chair: It is a relatively easy question. Did you embark on a rapid programme of growth?

Sir James Crosby: Yes. Sorry. The merger was predicated on a number of synergies. There were substantial efficiency savings and synergies; that counted for a material amount of revenue and profit, in the context of the pre-merger profitability of either organisation. There were also synergies around income products: selling Bank of Scotland’s business banking to Halifax customers; extending the provision of financial advice on investment insurance products, which was a Halifax business, to Bank of Scotland customers; and other things, and but the Bank of Scotland’s corporate bank being able to perform on a larger stage, essentially being able to underwrite lending rather than just being a taker of lending.

All those things added together to produce significant growth, but in those early years of the organisation the point is that the vast bulk of that growth agenda came from the commitments we made at the time of the merger, and which we thought were reasonable to pursue.

Q1265 Rory Phillips: Well, let’s look at the plan together. The first clue as to what you were about comes from the title: "Creating the new force in banking." You were trying to compete with the big four banks, weren’t you?

Sir James Crosby: Yes, we were very much trying to be a fifth force in banking.

Q1266 Rory Phillips: We can see that very clearly from the bottom of page 2 of the document, which says in bold: "This plan is about creating the new force in banking." And we can see, further on at page 20, the various ingredients of the plan. Again, it is in the middle of the page under table 4: "From the above table it can be seen that the ambitious growth plan does necessitate very active capital management." This was an ambitious growth plan, wasn’t it?

Sir James Crosby: Yes, based around, driven by the delivery of the merger synergies.

Q1267 Rory Phillips: We can see it specifically when we look at the numbers; for example, on corporate banking, which you have already mentioned and which are on page 18. Again, I am taking this in the simplest and quickest way we can. In the document, in bold, it says: "Corporate banking PBTE grows by around 22% per annum." That was the target that you as chief executive were setting for that division of the group, wasn’t it?

Sir James Crosby: Yes.

Q1268 Rory Phillips: And we can see that in numbers, on page 65 at the end of the document. If you look at the two tables there, the one on the bottom half shows what was projected to happen, according to the plan, to corporate loans. It is the second line of the table on the second half of the page. Corporate loans were projected to go from £35 billion to, in 2006, £96 billion, weren’t they? We can see similar increases across the piece, can’t we, so that total assets, just above that, go from £313 billion to £527 billion? That was the plan and that is how it turned out, isn’t it? The group did indeed grow rapidly over the next few years.

Sir James Crosby: It did grow rapidly, but not at that rate. I think it is important to stress that the way we produced these plans was that the first year was a budget; the second year was a plan; and the next two or three years were extrapolations. Quite frankly, we did not-although they were extrapolations of the original ambitions, we had no way of knowing whether they were going to be practical in the right market circumstances; and in fact although the business did grow very substantially over that period, it grew at different rates and by different amounts in different areas.

Q1269 Rory Phillips: But the overall-

Sir James Crosby: But I think overall it did grow less than these-for instance, in the corporate bank, the growth in balances was quite strong at the start, but much slower in 2004 and 2005, and by ’05 it was growing at 7% or 8%, which was a much lower rate than is shown here.

Q1270 Rory Phillips: But it is still the position, isn’t it, across the group as a whole that by the time you left, there had already been a substantial and rapid growth in the asset position?

Sir James Crosby: Yes.

Q1271 Rory Phillips: Thank you. There was not, however, was there, such a fast growth in the deposits?

Sir James Crosby: No.

Q1272 Rory Phillips: Indeed, is this right? Over the period when you were chief executive, the ratio between assets on the one hand and deposits on the other increased?

Sir James Crosby: Yes.

Q1273 Rory Phillips: Were you involved, please, in the preparation of the business plan for 2007 to 2011?

Sir James Crosby: No.

Q1274 Rory Phillips: That came after your time.

Sir James Crosby: Yes.

Q1275 Rory Phillips: Thank you. The suggestion I am going to put to you, Sir James, is this. Looking at it now, it is clear, isn’t it, that the group expanded too far and too fast?

Sir James Crosby: I think-at the time I was there, the fact of the matter was that we did expand very fast, but the performance of the business in terms of its impairments and risk factors was satisfactory. There is no doubt about that. Whether, with the benefit of hindsight, the business had a business model and had exposures that wouldn’t withstand the rigours of the financial crisis in 2007-that clearly was the case, but I am not sure I would accept that in the period up to 2005 we had expanded too fast.

Q1276 Rory Phillips: Go back to what Mr Hornby said about having eight or nine months to do something about it before the markets went wrong. Are you really suggesting to the commission that everything was in a good state when you left and it all went wrong in the eight or nine months-

Sir James Crosby: No, I am not suggesting that. I said at the start that with the benefit of hindsight we would all have done things differently and things could have been done better-that is self-evident, I would suggest, from what happened in the end-but I do not think it is right to say that the growth and what was achieved in the first few years necessarily meant that what happened was inevitable.

Q1277 Rory Phillips: You have used the expression "with hindsight". What I am suggesting to you is that it should at least have been obvious at the time that this rapid expansion was only sustainable-only workable-in favourable market conditions. Do you not accept that?

Sir James Crosby: Not entirely, because in the corporate book in 2002 and 2003 we experienced, as did everybody, a deterioration in credit conditions. The deterioration in credit conditions in the corporate book in 2002 and 2003 was very much what we would have expected in the context of that business. We also experienced significant stresses in the investment business in the bear market of 2003 and took a series of important actions to mitigate risk, which involved putting capital in, de-risking the balance sheet and reining back in on sales. In 2002 we also went into the market to raise capital, almost immediately after we agreed this plan as it currently is, as a means of strengthening the balance sheet of the business at what was, actually, not the most straightforward time economically. So I think there are a number of factors there that I think I would add to the picture.

Q1278Rory Phillips: Moving on in time, but still looking at the economic cycle that you have been talking about, can I ask you to go back to the FSA notice at F1, page 17, paragraph 4.54. That has the heading "The growth of the business in 2006". Do you see what it says there: "Prior to the start of 2006: the Firm had recognised that the economic cycle was at or reaching its peak"? Is that correct?

Sir James Crosby: Yes, in fact I think I said as much in my final annual report review for 2005; and I think that was why we were at the time very much slowing down our corporate loan book.

Q1279Rory Phillips: Well, you say that, but if you turn to the next page-page 18-you will see what the FSA explains actually happened in 2006, which in fact was not a slowing down at all.

Sir James Crosby: It was a slowing down of growth, yes-6% growth was the plan.

Q1280Rory Phillips: Yes, but look what they actually achieved in the year; if you look at 4.58. "UPBT growth of 17% (which was 8% ahead of plan); and lending growth of 8%." That is what actually happened in the year 2006. If you were giving these cautious messages that you are now explaining to the commission, they do not seem to have been received very clearly, do they, by the corporate division?

Sir James Crosby: No, but I think in practical terms during that year I would expect-it is not a question of who was in charge, but the reality is I was not there for that year in its entirety. I was there for the setting of the 6% objective. I was there for the setting of the PBT target; and although the PBT target was ahead of the lending growth that was largely because there was a plan to realise more equity positions, and that was an act of prudence rather than imprudence.

Q1281Rory Phillips: But presumably you were there in the first months of 2006 when the divisions were reporting their trends, and what they were up to, to the main group board?

Sir James Crosby: Yes, but I cannot recall precisely what they were reporting in terms of rates of growth; these things would move quite a lot over the year as a whole, and rightly or wrongly I was not in day-to-day charge, although I was holding the role of chief executive. I am not trying to abrogate responsibility; I am just saying in practice that is how we managed the transition from one chief executive to another.

Q1282Rory Phillips: Do you remember at any point before leaving the bank finally, at the end of June 2006, suggesting to the board that more should be done to act cautiously and prudently, as you have been saying?

Sir James Crosby: No, I would not claim that.

Q1283Rory Phillips: Going back to asset growth for a moment, and the failure, apart from anything else, of the deposits to keep pace with that, one of the consequences of that was that the group’s wholesale funding needs increased, wasn’t it?

Sir James Crosby: Yes.

Q1284Rory Phillips: And the Bank of Scotland part of the merged group was already heavily dependent on wholesale funding, wasn’t it?

Sir James Crosby: Before the merger, yes, but the aggregate business was less dependent than Bank of Scotland had been pre-merger.

Q1285Rory Phillips: Although in fact, is this not right, that as the years went on, including the years when you were chief executive, the wholesale funding position got more and more of a concern for the group as a whole?

Sir James Crosby: I think we always regarded wholesale funding as a key issue in the planning, so when we looked at any one year’s planning, one of the reasons for looking forward four or five years was to look at the sustainability of the plan from the perspective of funding. We regularly documented and saw that as a risk, but a risk to the strategy very much more than a risk to the bank because, as I think we document in the plan you were talking about earlier, if we had decided that there was not sustainable funding-by that one means a ready, diverse source of funds, which would not come at a price of higher cost of funding, an increased cost-if we concluded that that was not the case, we would have altered our strategy, because that is how we saw it. I think we say that very clearly in that 2002 to 2006 plan.

Q1286 Rory Phillips: Do you accept that the wholesale funding dependency was a problem, and still a problem when you ceased to be chief executive in mid-2006?

Sir James Crosby: It was always a risk to the way we planned the business’s development but, in our terms, it was not, in the absence of the rigours of the financial crisis and the extraordinary circumstances surrounding that. We did not see it as a risk to the bank, we saw it as a risk to our strategy, which is quite different.

Q1287 Rory Phillips: But if it was a problem, as Mr Hornby has put it in his statement to the Commission, it was a problem that proved to be insoluble, was it not?

Sir James Crosby: In the face of the near closure of wholesale markets for over a year, in the end it proved to be extraordinarily difficult.

Q1288 Rory Phillips: On the question of how significant the wholesale funding problem was, may I suggest this to you? That one of the flaws in your aggressive growth plan was precisely that it was significantly reliant on wholesale funding. Do you accept that?

Sir James Crosby: With the benefit of hindsight and knowing what we now know about the financial crisis and its nature, in terms of the closure of wholesale money markets-if we had known the nature of that crisis in the offing-absolutely. The financial crisis as it emerged was a stress test beyond anything anyone had considered. The circumstances were very different from anything that anyone had contemplated, and it had a whole range of impacts, not just on HBOS but on all sorts of financial institutions. The fact of the matter is, however, that it was that that crystallised the problem with the wholesale funding rate, but it was not a foreseeable scenario.

Q1289 Rory Phillips: Moving to the other problems of the group, you have made a number of comments in your statement to the Commission about the corporate division-we have already touched on this briefly. We estimate that the corporate impairments as at 2011 are of the order of £26 billion. That is an appalling figure, is it not, on any loan book?

Sir James Crosby: It is a very bad number.

Q1290 Rory Phillips: But it was not by any means the only disastrous area of lending, was it? The international division-again we estimate-has suffered impairments of nearly £15 billion. Are you aware of that?

Sir James Crosby: Yes.

Q1291 Rory Phillips: You talk about international expansion in your statement to the Commission-at C1, page 7, sub-paragraph 6. You explain the decision making there to go into the international markets. Principally, they were Ireland and Australia, were they not?

Sir James Crosby: Yes.

Q1292 Rory Phillips: Obviously, the commissioners read carefully what you have said there, but may I just cut to the chase on this? Bearing in mind the size of the numbers and the proportion of impairments compared with the size of the book, which is 30-odd per cent. in the international division, the truth is that these are examples of very bad lending, are they not?

Sir James Crosby: Yes, I think so, but in Ireland-these were both markets that Bank of Scotland had been in for some time. The growth was from a small base, but the reality is that the Irish market in particular experienced extraordinarily difficult conditions.

Q1293 Rory Phillips: Yes, but that certainly cannot be said, as you would concede, in relation to Australia, which seems more or less to have escaped, and yet the international division has racked up impairments of £3.6 billion in Australia. That is an appalling lending record, is it not?

Sir James Crosby: I agree.

Q1294 Rory Phillips: Thank you. So far as the corporate business is concerned, you touch on the problems that have emanated from corporate. At the end of section 2(1) on page 1 at C1 of your statement, you talk about the significant deterioration in corporate loans and say, "That can only be because HBOS was taking more risk than it understood was the case at the time." In other words, they simply did not know what they were getting into-to use simple language.

Sir James Crosby: I think what I was saying was that even allowing for the exceptional circumstances of the financial crisis, the level of impairments was such that that could not be the sole explanation. While it had not been apparent through all our work and analysis throughout those early years-and because it had not been apparent-there must have been some aspect of that that was not understood properly. The truth is, as I said earlier, that in 2002-03, the credit experience and the corporate book were very much as we had expected. It deteriorated, but it deteriorated in ways that were entirely consistent with the market environment. That was very clearly not the case in the midst of the financial crisis, and that was what I was accepting in that observation.

Q1295 Rory Phillips: Yes, but the corporate book, as written by the Bank of Scotland and then, as you said, expanded in HBOS, was always a high-risk book, was it not?

Sir James Crosby: It always had the same characteristics as it did. The mix of business was very similar, both pre and post-merger. Those were the markets where Bank of Scotland had established its expertise. Those were the markets that it had entered in the ’80s and ’90s in order to build up its market position in corporate banking.

Q1296 Rory Phillips: You were well aware of all of the features of the book?

Sir James Crosby: Yes, in the broader sense.

Q1297 Rory Phillips: They are described in the FSA final notice at page 8 of F1: "The risk profile of the corporate book was high." Then it talks about concentration risk and substantial exposure to equity, substantial exposure to largely highly leveraged transactions and the credit quality of the portfolio being low. You were well aware, were you not, of all of those features of the book?

Sir James Crosby: A lot of those features had always been features of the Bank of Scotland corporate book, but the structure of loans had been managed successfully by substantially the same team as we had running the corporate book through a number of downturns.

Q1298 Rory Phillips: The Bank of Scotland had done well out of the 1990s crisis, hadn’t it?

Sir James Crosby: I am not sure that I would sign up to that language, but I think that the business had been successful through a number of downturns.

Q1299 Rory Phillips: Do you think that that made them complacent about economic conditions as they later experienced them, say towards the end of your time as chief executive?

Sir James Crosby: I do not think so, no. It was always a good thing, in my judgment, to have people making lending decisions who had experienced and lived through downturns. They had very deep-seated experience over a large number of years, so, no, I do not believe it gave rise to complacency. That was not my sense; I certainly believe that there are huge advantages in having such an experienced team who had lived through all those downturns.

Q1300 Rory Phillips: Obviously, despite that huge experience, what they actually produced was disastrous in terms of numbers. You have to accept that, surely.

Sir James Crosby: Yes, it gave rise to very bad impairments.

Q1301 Rory Phillips: Did you, with hindsight, perhaps place too much confidence in their expertise?

Sir James Crosby: I think, inevitably, to some extent that must be true. They were a highly regarded and very experienced team with a terrific track record.

Q1302 Rory Phillips: The truth is surely that the demise of HBOS shows, among other things, that the model the Bank of Scotland had successfully worked with through the ’90s simply did not work on the much larger scale of HBOS.

Sir James Crosby: No, I do not think it shows that. It is hard to conclude that, because in the early years of the merger it worked well, and it worked well under credit stress. It clearly gave rise to very bad results in the midst of the financial crisis, and there is a whole raft of reasons for that, but some of those are associated with the effect that the prolonged closure of wholesale markets had on various different markets. In the end, closing the wholesale funding markets affected those asset markets that were dependent on continued access to funding, such as commercial property; it broke down the diversification risk. All sorts of risks that historically had been assumed not to be correlated became very closely correlated. It accelerated crystallisation of risk.

All those things happened at the same time. Yes, they happened in a way that affected Bank of Scotland Corporate much worse than other banks, but a lot of them were peculiar features of the financial crisis that we had not seen before and were, to a large extent, unforeseeable.

Q1303 Rory Phillips: Just looking at that answer, you rightly said that these were global forces that affected the entire banking system, but the truth is that it affected this part of this group worse than any other UK bank. Why?

Sir James Crosby: I agree with that, but as I said in my evidence, I think it is partly because of the way that the financial crisis affected the markets that Bank of Scotland Corporate was in, and it is partly because, with the benefit of hindsight, the risks that the corporate bank was taking were not as well understood as everybody thought.

Q1304 Rory Phillips: To what extent do you think that the divisional structure of the group contributed to its problems?

Sir James Crosby: The divisional structure came about in the merger because, in our judgment, that was the best way to capture the various areas of expertise within the business. So the corporate bank of HBOS was very largely the corporate bank of Bank of Scotland, and the retail bank was, vice versa, with Halifax. I guess the insurance and investment arms were very largely Halifax, because Bank of Scotland did not operate in those areas. That was a very practical way of deploying the various areas of expertise we had in the right areas. I am not sure whether the divisional structure, as such, altered that and made it more difficult.

Q1305 Rory Phillips: Did that not make it more difficult for effective control and challenge to be exercised from the centre?

Sir James Crosby: I don’t think so, in the sense that we had group risk functions, which had the capability to challenge. They were responsible for setting policies, and they were there for macro-analysis of risks and risk trends. We had, in the executive directors, people experienced in one part of the business who were running another, who were there and could challenge, and of course we had a board of non-executives. We also had established, post-merger, a divisional risk control structure, so there were specialist audit risk committees-with more combined audit and risk in those days-that operated in each division. We had a lot that enabled us to challenge what was happening in the divisions.

Q1306 Rory Phillips: And yet you were obviously taken by surprise by what was actually going on in the corporate division’s book.

Sir James Crosby: I was not taken by surprise at what was going on while I was in charge. I was taken by surprise, as I think everybody was, by the out-turn after the financial crisis, which I assume is what you meant.

Q1307 Rory Phillips: Do you think the quality of the management information that was coming up to the centre from the divisions was adequate for you to assess what they were actually doing?

Sir James Crosby: Well, I think we felt confident with the management information we had. As a board, we had a very full and regular flow of management information, which covered performance indicators and risk indicators. It was a very open and transparent communication from both the management who ran the business and those at the centre who provided oversight. I think the style and the narrative of the communication was very open and transparent. Issues were put in very sharp profile, so that people could-it was a great platform for challenge. The culture was one of openness and transparency in that sense, and that is really important. Where we saw weaknesses in management information systems, we did all that we could to improve them. The reality is that, with the benefit of hindsight, we all have seen ways of having better management information, but we were certainly not aware that our management information systems were a source of weakness.

Q1308 Rory Phillips: Can I cover two more points? The first is about board qualifications and experience. In terms of the executive directors, I think that I am right in saying that the only two with corporate banking experience were Colin Matthew and the heads of the corporate division-first, George Mitchell and then Peter Cummings. Is that right?

Sir James Crosby: Latterly that was the case. At the earlier stages, there was Gordon McQueen, and briefly Peter Burt.

Q1309 Rory Phillips: Was not that a weakness in the executive profile of the board? There were really only the Bank of Scotland people who had the deep banking experience to which you referred.

Sir James Crosby: From corporate banking?

Rory Phillips: Yes.

Sir James Crosby: Certainly, in the period post-merger, I think that was an inevitability of the merger, in the sense that, although Halifax had some corporate banking activities, they were very specialised and very modest. We did not have the high-level experience that could add to that. I would also say that Mike Ellis had quite broad experience of banking as well and was incredibly well positioned to challenge.

Q1310 Rory Phillips: When you take that lack of experience-as I have suggested it-coupled with the divisional structure, didn’t it actually mean that the heads of division were pretty much able to set their own course in their own independent fiefdoms within the group?

Sir James Crosby: No, I don’t think so actually. I think this is important. Can I approach that from two different directions? In the first instance, when we looked at the board structure-both the non-executive structure and the executive board structure-we had to consider the variety of risks that we took in the business, not just the corporate bank. There were the insurance and the investment risks and the retail banking area, as well as the corporate bank. We had a good breadth of experience when you looked across all those areas. If we had had more people with corporate banking experience, we probably would have ended up with a much larger top executive board and group board, in reality, because of the diversity. That was the first point.

The second was that the challenge process in your terms-of setting ambitions around the planning process-was very rigorous. We started each summer with a planning framework document, which was a top-down approach that looked at the various resources we had and the market judgments we were making about where markets were and their attractiveness-by resources, I mean people, finance, funding, and so on-and we set a broad envelope within which we then asked divisions to plan. That broad envelope and the planning framework were the result of significant challenge between the centre and the divisions. They were the result of significant debate around the executive board and with the main board, and it was part of the process-at the core of the planning process. After that, the divisions built their plans in detail. Essentially, that was a one-year budget with extrapolations thereafter, and during that process, there was also significant challenge. I do not think it would be right to argue that that was divisions setting their direction as fiefdoms, because I think it was very much drawn together in terms of the overall view of what the business was trying to achieve, and it was done so through a rather detailed process, which I have just alluded to.

Q1311 Rory Phillips: Can I take an example of that, finally? The Commission has heard evidence about the process of interaction between divisions and the centre, in which the divisional experience was that growth targets were required to be increased by the centre, rather than the other way round. Can you think of examples where you in the centre were saying to divisions, "Rein it in a bit. Limit your targets. Reduce your targets."?

Sir James Crosby: Yes, very clearly. It may not have been difficult to agree; but certainly, George Mitchell and I, when he was heading corporate banking, talked and I would challenge him to reduce growth targets, in terms of asset growth, cyclically. Maybe he agreed or maybe we debated it, but we certainly did so. We certainly challenged, in the retail business, mortgage volumes, and we ceded market share in the mortgage market, which was after all, our core market, in 2004 and 2005. We cut back significantly on volume in some of the investment businesses in the wake of the 2003 bear markets-so no, there very much was challenge. There was challenge on a lot of parameters, but as you would expect, and as was appropriate, the challenge was in both directions.

Q1312 Rory Phillips: Yet the net effect of all this across the group, moving out from the divisions, was, as I have suggested, that growth continued throughout the period that you were chief executive.

Sir James Crosby: Yes.

Q1313 Lord Turnbull: Sir James, although you left the business some time before the crash, you acknowledge that there were events and decisions taken in the prior period which you were associated with, and I would like to explore that a bit further. As a chief executive, you were the founder CEO of the merged business, and presumably, an important part of your job was to set the first strategic plan. Is that right?

Sir James Crosby: Yes.

Q1314 Lord Turnbull: If you look at that plan, it is ambitious and possibly aggressive, in terms of its overall targets. You wanted to increase the rate of return on equity very substantially and earnings per share. The components would be that across the piece in almost all the businesses that HBOS was involved in-whether it was corporate, international, treasury, or retail mortgages-you expanded, but in all those cases, you significantly expanded the risks that you were taking.

Sir James Crosby: Not necessarily, no. In what way do you mean that?

Q1315 Lord Turnbull: If you take mortgages, you were notable for going in for what might be called, euphemistically, specialised mortgages, which meant right-to-buy self-certification to even a greater extent than-

Sir James Crosby: We had been in those markets before the merger.

Q1316 Lord Turnbull: But they were expanded under this plan.

Sir James Crosby: They were. They offered the-

Q1317 Lord Turnbull: You clearly had a deliberate plan to expand the international business into Ireland and Australia, and corporate has-

Sir James Crosby: But that was much later-the Ireland and Australia expansion-it was not immediately post-merger.

Q1318 Lord Turnbull: On the corporate expansion and particularly the style of it, first, you expanded the lendings substantially. The commercial property component of that grew even faster. There was a substantial increase in single credit-that is, loans to particular single entrepreneurs. Just to illustrate that, could you look at G8? This is a schedule of the facilities granted over £20 million. At that time, in 2002, shortly after-a year and a bit after-you got started, you had five loans of over £500 million. Okay?

Sir James Crosby: Yes.

Q1319 Lord Turnbull: If you move on to G10, which is September 2006-this is more or less where it had got to at the point that you left-you will see that on the whole of that first page, there are 17 loans over £500,000 to individual borrowers, two of them around £2 billion to individual borrowers. Now, if that is not a definition of taking on more risk, I do not know what is. There was an appetite to take more risk.

Sir James Crosby: I agree with that, as articulated, but obviously that was on a much larger balance sheet and a much larger corporate loan book, and we had moved into a world where we were-one of the reasons why the merger was attractive to Bank of Scotland Corporate was the capacity to lead and sell-down loans, rather just-

Q1320 Lord Turnbull: But these loans of £2 billion were not to the FTSE 25-not to the BPs and Vodafones of this world. These were largely to entrepreneurs engaged in property-related businesses.

Sir James Crosby: I would not say that they were largely property related, but there were-that aside is a reasonable-

Q1321 Lord Turnbull: And the whole of this is then based on a funding strategy, which in itself is risky and was acknowledged as such at the time.

Chair: You are agreeing with that. You nodded your head in agreement, but maybe you are not really agreeing. Let us have an answer to that. Are you agreeing, Sir James?

Sir James Crosby: I think there were risks associated with the sustainability, but we always monitored those very closely, and as I said earlier on, the risks that we judged around the funding were with our ability to pursue the strategy, rather than risks to the bank. I think that is the difference.

Q1322 Lord Turnbull: If you go to G3, the first corporate plan-it could be the second-and go to page 30 of that, this is the "Group business plan. Creating the new force in business banking." There is a heading: "Funding. This is becoming a"-

Sir James Crosby: I am sorry, but which page is it?

Lord Turnbull: Okay. I am going too fast for you. Page 30.

Sir James Crosby: Yes, I am on page 30.

Lord Turnbull: Okay. It says, "Funding. This is becoming a more serious risk, particularly in a low interest rate environment, as the growth in assets is not being funded by a proportionate increase in customer deposits, placing greater strain on Treasury’s ability to fund the growth through wholesale sources." It was known, from the inception, that the funding model was risky.

Sir James Crosby: Yes; again, I think the point there is that we saw the risk in terms of our ability to sustain the funding plan over a five-year period, rather than as a risk to the bank per se. I think we also say, at the bottom of that page: "In the final analysis, we would need to restrict asset growth we could not fund at acceptable cost."

Q1323 Lord Turnbull: When asset growth continued, at best it got to the point where, as you say in your own evidence, from about 2006 onwards, asset growth and liability growth were roughly the same, but as a mathematician, you will know that the gap will get bigger.

Sir James Crosby: The rate at which-if both are growing at 6%, the funding gap grows at 6%.

Q1324 Lord Turnbull: By the time you get there-admittedly, after your time-the corporate treasurer is saying things like, "You realise, of course, that our wholesale funding requirement is bigger than all the other banks’ put together." Our case is that you have developed a high-risk growth of assets and built it on a high-risk funding model. You told us, and you repeated it in your own evidence, that there are feedback mechanisms between asset prices and funding. When one goes wrong, it will affect the other and so on. You argued that the business was predicated on synergies. What you seem to have overlooked is that the risks in the business were not diversifying each other, but were compounding. As an actuary, don’t you think you should have spotted that?

Sir James Crosby: I am sorry-I am not trying to be awkward-could you rehearse that for me?

Q1325 Lord Turnbull: You have acknowledged, in your own evidence and also now orally, that there are feedback mechanisms between the growth of assets and funding; if one goes wrong, it will cause problems to the other. You have a business model in which risks in the business are not diversifying, but compounding.

Sir James Crosby: I see the point you are making, but I think that what I was saying was that the particular form of the crisis, which was the closure of the wholesale funding markets, was broadly indiscriminate in the impact it had on different markets. In fact, it acted against diversification effects in a way that was particular to that crisis, that we had not seen before and which I think most people would regard as unforeseeable. That was, in your terms, the "feedback effect".

Q1326 Lord Turnbull: What you thought was a diversified model turned out to have compounding effects. I am saying that, as an actuary, you might have spotted that, but-

Sir James Crosby: Yes, but what I think I was clear about was that the nature of the financial crisis broke down some of those diversification barriers, and we saw that all over the place, realistically. It broke down the extent of the diversification that was inherent in our business model and in the nature of the risks that we took.

Q1327 Lord Turnbull: What has consistently come through from you and other witnesses is that this could not have been foreseen, and yet-

Sir James Crosby: The nature of the crisis could not have been foreseen; I think that is the precise-

Q1328 Lord Turnbull: You had a risky model. You were getting warnings on this as early as December 2002. You get a letter from the FSA saying-I am paraphrasing slightly-"We are worried that the risk infrastructure is not keeping pace with the growth of assets." You get another letter, directed particularly at corporate, in December 2003, which is then discussed. In the minutes of 27 January-G1, page 5-after a flurry of correspondence with the FSA, the finance director states: "The FSA’s perspective was that the group’s growth had outpaced the ability to control risks," having been warned about that, as I said, a year earlier. "The group’s strong growth, which was markedly different from the position of the peer group, may have given rise to ‘an accident waiting to happen’." I think this might be Mike Ellis’s paraphrase of what the FSA was saying. We have not found the document in which it appears, but, "an accident waiting to happen"-it was and it did. The idea that you could never have foreseen problems, given the warnings you were getting, does not really work.

Sir James Crosby: Can I just come back on the particular part here in the process? That language was Mike Ellis’s. That was him essentially getting everybody around the board table to the same place in terms of how seriously we should take the perfectly legitimate challenges from the FSA. Remember, we had to pull this merger together in the last part of 2001, and the FSA were naturally very closely interested in how that new organisation was coming together, and whether and to what extent the new governance and risk management systems that we had put in-quite a significant investment at the time, in terms of those systems-were taking effect. This was their feedback that came through in the ARROW report of that year.

As a result of the discussion, we took incredibly seriously the initiatives that were necessary to remedy the flaws. We took those initiatives through over the next year and to the satisfaction of the independent reporters. We had the skilled person report from PwC. They were also endorsed by the FSA themselves, who subsequently brought down the ICR-the capital ratio-in response. As a new group, we were alerted to the fact that our control infrastructure needed more work. We tackled it with huge commitment. The board had very close oversight, and then we got that level of assurance. I know that that is not necessarily answering your question, but the context is important.

Q1329 Lord Turnbull: What you are coming to is a different story, which is the FSA having discovered precisely the two weaknesses that brought you down. One was a risky asset, particularly in corporate. The second was the funding model. Having found the treasure, you then buried it again and did not find it until 2007, and that is a problem of regulatory failure, which we as a Commission will need to investigate. But the warning signs were there. You tried to deal with this by lengthening the maturity of your funding. As Mr Phillips has explained, because the gap was getting bigger all the time, you never managed to keep up with it. The amount of short-term funding remained very high, and right through to the end-what was identified as a key weakness of the company-you never got on top of it.

Sir James Crosby: Are you talking about funding or the corporate?

Q1330 Lord Turnbull: I am talking about funding.

Sir James Crosby: We did lengthen the maturity of the funding very successfully. But the actual quantum that was less than one year was roughly the same-slightly higher at the end than it was at the start. A lot of that was the logical consequence of longer-dated wholesale funding rolling down. We substantially lengthened it and we did so at significant cost to the profit and loss account.

Q1331 Lord Turnbull: What you never got to was a point where the deposit growth exceeded the growth of assets. You brought them roughly into parity but at a time which still left this deficit growing. It turned out to be an Achilles heel. I don’t know whether you accept that. Having been concerned about it, you never ever got to grips with or got on top of this problem.

Sir James Crosby: The other context I would add to that is that during this period we deepened our access to wholesale funding markets through the securitisation markets and the emergence of the covered bond market. The fact of the matter was that securitisation of mortgages was quite a good way of wholesale funding because the length of the wholesale funding matched very closely the assets. So it was not a case of saying, "All wholesale funding is a challenge relative to deposits", because it is equally true that the deposits we were trying to grow-and it is really important to grow the stable deposits that you can think of as a secure base for funding the bank. I think we made very significant progress in a market that was developing very fast in terms of funding vehicles, and the lengthening of the maturity of that wholesale funding was very significant. We were longer dated than most of our peers in that respect. It was right that we should be, but we were and we made significant progress there.

Q1332 Lord Turnbull: History showed that the lengthening of that funding simply delayed the point at which the inevitable took over.

Sir James Crosby: As I say, I was not there at that stage but looking in from outside I would agree in the specific circumstances of this crisis. Again, that was a prolonged closure of markets of over a year. That was a particular aspect that, rightly or wrongly, none of us-

Q1333 Lord Turnbull: But you had managed to set yourself up in a way that meant that you were particularly vulnerable-more so than others. You had adopted a structure, a business model that made you in a sense the most vulnerable of all the banks to this crisis. They were all conscious decisions.

Sir James Crosby: They were not conscious-all the decisions we made in developing that were clearly conscious decisions, but they were not conscious of this particular scenario, which I think is the important point.

Q1334 Lord Turnbull: In your evidence at paragraph 4.1 you make a particularly interesting observation. It is on the question of whether the board, even if made up of very able people, had the right collective experience. You say that "the creation of HBOS was inspired by the belief that a diverse funding services conglomerate embracing most aspects of financial services will be greatly advantaged. One consequence, however, was that the main board required diverse experience across a broad range of financial services business. It was therefore always unlikely to have the concentration of banking expertise among its non-executives as might be, for example, for a business concentrating entirely on banking." Couldn’t you summarise that as "too big to manage"?

Sir James Crosby: We didn’t think so at the time. We believed that the diversity of risks was a strong business model for the future and in particular, recalling that the heart of the business was a retail banking environment where we were in practice talking about investment products, retail banking products and insurance products. So we saw great strength from that, but in the context of the concentration of specialist expertise that you might have round a board table, I think it was inevitably one consequence. But if you look at the board that we had, was it materially different, in terms of its skills and backgrounds, from boards that were more concentrated on banking? Probably not. That was the context of the day, to some extent.

Q1335 Chair: You said a moment ago-correct it if you want-that you can think of deposits as a secure basis for growing the business. You are happy with that remark?

Sir James Crosby: The point I was making was that within deposit-based funding of a bank, there are certain types of deposit that are so unstable that you do not necessarily regard them as anywhere near as solid a basis for funding a bank as stable deposits. That was the only point I was making.

Q1336 Chair: You are not making the point that deposits are a safer basis for growing a bank than wholesale funding.

Sir James Crosby: I think-

Q1337 Chair: You think they are about the same risk?

Sir James Crosby: No, I do not. I think-

Q1338 Chair: Which one is the riskier one?

Sir James Crosby: I would think that secure deposits, on balance, are a safer basis for funding a bank, but I was making the point that not all deposits are of that type and that some types of wholesale funding fitted very naturally alongside the assets.

Q1339 Chair: "On balance" was the phrase you used a moment ago. On balance, deposits are a more secure basis for growing a bank than wholesale funding-correct or incorrect?

Sir James Crosby: Yes, I agree with that.

Q1340 Chair: And you thought that at the time, too. It is not something you have discovered with the advantage of hindsight?

Sir James Crosby: No.

Q1341 Chair: If we go back to the period when you were running this bank or the lion’s share of the period when you were running this bank, the loan-deposit ratio rose sharply, didn’t it? So you recognised that you were moving from a secure to a less secure basis for funding the bank, funding the growth.

Sir James Crosby: Less secure in the sense of access to funding. As I have already said, from a wholesale funding point of view, we looked very carefully each year in the planning process at our ability to fund the wholesale funding requirements of the plan, and we saw that fundamentally as a risk to our strategy rather than as a risk to the bank.

Q1342 Chair: While you were growing this deposit ratio from 141% to 196% or on its way to 196%, did you think you were making the bank more secure?

Sir James Crosby: No, but I did not think we were making it materially less secure, because of the-we believed that that wholesale funding was sustainable; we would not have done it otherwise. It involved quite significant growth in securitisation, where the wholesale funding maturity was matched to the assets. That was a big part of that. But I did not believe that we were making it more insecure, because we believed that that wholesale funding was sustainable.

Q1343 Chair: Would it be fair to say that I could summarise your evidence as saying that all banks were hit by this unforeseeable tsunami-the financial crisis, with its unique characteristics, which did enormous damage everywhere-and you got hit like the rest of them?

Sir James Crosby: No; as I say in my evidence, I think that there were clearly, in the corporate banking area-we were hit worse. Some of that was the mix of assets we had, but some of it was down to the measurement and judgment around risk, and I was very clear about-

Q1344 Chair: The measurement and judgment around risk-

Sir James Crosby: In the corporate bank.

Chair: Is that a euphemism for mistakes-

Sir James Crosby: Yes, but I think-

Chair: Blunders-

Sir James Crosby: I am quite honest about that in my evidence and I do not think I would alter that now.

1345 Chair: And incompetence. You would agree with that?

Sir James Crosby: With the benefit of hindsight, we would have done-

Chair: No, I am not asking you-

Sir James Crosby: With the benefit of hindsight, I am sure we would have done things differently.

Q1346 Chair: No, I am not asking you that. I am saying: do you recognise that this was incompetent lending?

Sir James Crosby: With the benefit of hindsight, I am sure it was not good lending, and the fact of the matter is-

Q1347 Chair: I will give you another go. With the benefit of hindsight, was this incompetent lending?

Sir James Crosby: I do not think it was incompetent, in the sense that we always acted-we always believed and my colleagues in the corporate bank always believed that they had a good and clear understanding of the risks they were taking and we in aggregate as a bank had no evidence to the contrary.

Q1348 Chair: With the benefit of hindsight, was this competent lending?

Sir James Crosby: Was it a good balance between risk and reward in that sense? Probably not, given the impairments that emerged.

Q1349 Chair: With the benefit of hindsight, was this competent lending?

Sir James Crosby: If by competent lending, we are accepting that the right balance with the benefit of hindsight was struck between risk and reward, then no, because that was the level of-

Q1350 Chair: So it was incompetent lending.

Sir James Crosby: By that definition.

Q1351 Chair: It is your definition.

Sir James Crosby: I would not describe it as incompetent, because I think it was done by individuals who were well intentioned and acting in good faith at the time. With the benefit of hindsight, I would not use that language to describe it.

Q1352 Chair: I am still-and, indeed everybody watching this will be-wondering whether you are clear that incompetent lending was made by your bank during this period. Do you want to have another go?

Sir James Crosby: I think it is self-evident that the level of impairments in the corporate bank could not be explained solely by the financial crisis and I was very clear about that in my evidence.

Q1353 Chair: If we turn to looking at the out-turn of all this-the consequences-would you agree that a good measure of the degree of incompetent lending would be the level of impairment?

Sir James Crosby: Yes.

Q1354 Chair: Do you know roughly what the level of impairment is in HBOS at the moment?

Sir James Crosby: I have only seen the data that you quoted and that is in the first few pages.

Q1355 Chair: And roughly what is it as a proportion of the loan book?

Sir James Crosby: I do not know an aggregate; I have not got it.

Q1356 Chair: I am just interested partly to know whether you know this core number, since it is the core measure.

Sir James Crosby: I could not quote it, no. I have looked at the data.

Q1357 Chair: Roughly, it is a little over 10%-10.5%.

Sir James Crosby: Yes. Sorry, in that measure, yes, it is 10%.

Q1358 Chair: Do you happen to know roughly what it is for the other main banks?

Sir James Crosby: I think it was, in that context, 5% for the Royal Bank of Scotland and 3% or 4% for the others. It is an awful result.

Q1359 Chair: It is not just an awful result, though, is it Sir James? It is a much worse result than all the other banks. Just to take RBS, which also went down the tubes, it has an impairment of less than half the impairment that the bank that you were running has suffered.

Sir James Crosby: When I say it was a very bad result, I am saying that in the context of it relative to other banks. You would expect a bank to have impairments in a downturn, but you would not expect impairments of this order, which was very clear from my evidence and which I am reiterating today.

Q1360 Chair: Would you expect impairments to be less bad or worse, all things being equal, in banks that have large stable mortgage exposure?

Sir James Crosby: I would expect them to be less, if that was the dominant part of the business, but there was a mix of businesses.

Q1361 Chair: What kind of business did you take over?

Sir James Crosby: A large stable mortgage bank.

Q1362 Chair: This large stable mortgage bank, which should have even lower impairments than the average, has now got impairments of double the next worst bank, and that one went down the tubes. Let’s just go back to these earlier questions. Do you think that this lending was incompetent?

Sir James Crosby: With the benefit of hindsight, it was not competent.

Q1363 Chair: It was incompetent. You are happy to say that.

Sir James Crosby: Yes.

Q1364 Chair: Do you think therefore that this might have something to do with the fact that this tsunami that came with the financial crisis did far more damage to your bank than to any of the others?

Sir James Crosby: Yes, and that is what I say in my evidence.

Q1365 Chair: Therefore it is incompetence that brought this bank down.

Sir James Crosby: I think it is very important to stress that we all believed that everybody was acting in good faith at the time.

Q1366 Chair: No one has argued bad faith here. I am not asking about bad faith; I am asking about competence. Are you agreed that incompetence brought down this bank?

Sir James Crosby: I will agree that, in the end, the corporate banking losses were excessive in the context even of the financial crisis and that the lending in those terms was very poor in terms of the out-turn. I think we have all said that.

Q1367 Chair: You have agreed, after exchanges of almost Paxman-like proportions, that the lending was incompetent.

Sir James Crosby: I apologise for that.

Q1368 Chair: So we have arrived, slowly, at the point where we are agreed that a key bit of what this bank was doing was incompetent. Now, we are trying to form a connection between that and the failure of the bank. It is really very basic stuff, and I am asking you whether that is what brought this bank down.

Sir James Crosby: It is clear that although the financial crisis was the trigger-

Q1369 Chair: It would help hugely if you said yes or no to that. Either it did bring it down or it did not.

Sir James Crosby: The corporate banking loans and the impairments there did bring it down. There is no doubt about it.

Q1370 Chair: Okay, so therefore it was this incompetence that brought the bank down. Is that correct or incorrect?

Sir James Crosby: Correct.

Q1371 Mr Love: I want to come back to the theme that Lord Turnbull finished on earlier just before the Chairman’s questions. It is really in relation to corporate governance issues and the roles of the board and the non-executive directors. When you set up HBOS with Lord Stevenson, what discussions did you have about what the appropriate board structure and activities were?

Sir James Crosby: Initially, we were creating a merger and we brought together a mix of non-executive directors from both boards. We looked at the balance of skills that that brought. That was partly because the non-executive directors from Bank of Scotland knew the Bank of Scotland business well and were experienced in its activities. The same was true of the Halifax. We then had a mix of executive directors-I think it was roughly an even number from each-who brought their different experiences to the table, so in practice we were trying to build as balanced a team as we could. We brought in Phil Hodkinson, who came from an insurance background, because we needed that expertise at that time and that was the one non-Halifax Bank of Scotland source of skill base that we brought in at the start.

Q1372 Mr Love: If I could characterise that answer, you simply took a bit of each and added one outside director and never really gave it much thought at all.

Sir James Crosby: No. I think we gave it a lot of consideration. We were building the mix of the board in accordance with the two boards that they came from.

Q1373 Mr Love: We have heard from other witnesses that the board met once a month and that the normal time that elapsed between beginning and end was around two hours. Do you think that two hours once a month for such, as you admitted to Lord Turnbull, a large and complex organisation was appropriate in the circumstances?

Sir James Crosby: It was generally longer that that, but that is a point of detail. The fact of the matter is that non-executive directors engaged with the business in all sorts of other ways as well in terms of the risk control committees and the audit committee and they gave up considerable time in that context. So it was not just the board meetings.

Q1374 Mr Love: Would you accept the characterisation that a board meeting that lasts two hours, with so many things to deal with, will end up being a rubber stamp for the executives?

Sir James Crosby: It was not. We had very lively debates. I think our chairman was good at encouraging the board to focus on the substantive issues before them, so that we could, within an acceptable time frame of the meeting, have good discussions on the substantive issues.

Q1375 Mr Love: You accepted earlier on that one of the main focuses of board activity for non-executive directors is to challenge the activities of the organisation. What opportunities for challenge would there be in a meeting that takes place for two hours? This is the main opportunity for non-executive directors to undertake their duties as non-executive directors. How could they do that?

Sir James Crosby: Throughout the agenda. What we did was focus time on the main issues there. Typically, it would be the month’s report on the management information and if there were planning papers, there would quite likely be a risk debate around one aspect of risk, and there would be a strategic review of parts of the business, so the meeting was set up around the key issues. Frankly, I do not recognise the board meeting being two hours. They were more like three hours, which was a much more normal length. But the reality is that they were a lively forum for debate, and we debated the main issues very successfully. And the style of the minutes supports that contention.

Q1376 Mr Love: Let me just ask one final question on this matter. You brought together people from Bank of Scotland and from Halifax, and you added to them. There is some concern-again, it has been expressed to us in this Commission-that there were so many people on the board that you never really got an opportunity to say anything very much in short board meetings. Do you recognise that as a criticism?

Sir James Crosby: We were a larger board than you’d see for many plcs, but that is true of banks generally. And it was partly because we needed a non-executive board that was sufficient in number and capability to populate the risk control committees in the different areas. So we were a little constrained. Accepting the theory that very often small boards are more effective, we couldn’t become a very small board because we needed the population to have the time and availability to devote to the breadth of the business.

Q1377 Mr Love: I thought for a moment that you were going to say, "and the expertise". Sadly, however, regarding your non-executive directors, earlier on in questioning Mr Phillips raised the issue of corporate banking experience among the executives. There was no corporate banking experience among the non-executives and therefore how could they, in such a complex and technical area, issue that challenge that is so important for a board of directors?

Sir James Crosby: Certainly we had people experienced in other financial areas who would understand the corporate banking well enough to challenge it. We also had deep-seated industrialists with deep-seated experience of corporate banking markets from that side. So, yes, there were people there who could challenge it from the non-executive perspective.

Q1378 Mr Love: Let me put one final question to you. Mr Phillips mentioned fiefdoms. Everyone recognises that in the structure of HBOS the divisions were very strong-uniquely, unusually strong-compared with the centre. In those circumstances, especially where those in corporate banking had vast experience of corporate banking, wasn’t it critically important that the central organisation-the board of directors-should have on it someone, or persons, who had corporate banking experience to offer that challenge to what was going on and to what you have already indicated was the source of the failure of HBOS in the longer term?

Sir James Crosby: With the benefit of hindsight, but the reality is that I believe we had non-executive directors who could issue that challenge and we also had other executive directors around the table who had corporate banking experience and who were only too ready to issue the challenge.

Q1379 Baroness Kramer: Just a moment ago, you mentioned sell-down and syndications. So what role did sell-down and syndications play in your credit risk management strategy?

Sir James Crosby: One of the shifts in what happened with the Bank of Scotland’s corporate banking business when it became part of HBOS was that it was better able to be the lead bank in transactions than it was hitherto, and that involved selling down agreed proportions of loans. It also involved developing the skills and the marketing and distribution capability to do that. In the first year or two after the merger, we built up the capability in that area.

Q1380 Baroness Kramer: In fact, you became a major syndicator?

Sir James Crosby: I think we were a significant syndicator, yes.

Q1381 Baroness Kramer: So, given that the "stuffee" market is a highly volatile one, you basically built up credit in terms of the loan assets with pretty high-risk loans. You had a fairly risky funding strategy with such a dependency on wholesale, and a key element of your risk management was the ability to sell down and syndicate, which was also highly volatile and usually first out the door.

Sir James Crosby: It was a key element of our strategy; our strategy was to sell down loans, and we were successful in so doing.

Q1382 Baroness Kramer: You would agree, would you not, that good intentions and competence are two different things?

Sir James Crosby: Yes.

Q1383 Baroness Kramer: So, given that none of us would suggest that a corporate bank, the corporate division and others, lacked good intentions, wasn’t it particularly important, given the growth strategy that you were pursuing, that there should be a strong, powerful, independent reviewer of risk within your organisation?

Sir James Crosby: Yes.

Q1384 Baroness Kramer: In 2003, I think your own comments were, "We accept the need to make more progress in some areas, notably the relationship between group risk and divisional risk functions." The divisional risk function was the independent function.

Sir James Crosby: Can I ask where you are reading that from?

Q1385 Baroness Kramer: Your letter to the FSA of 12 March 2003. So, even you had concerns about the relationship between the embedded operational risk function and the independence function.

Sir James Crosby: I think I was recognising that there was room for improvement. Clearly that was the case at that time, and we made significant improvements in that area.

Q1386 Baroness Kramer: That is interesting because Paul Moore, whose evidence was given to the panel, described the culture between the group risk functions and the divisional risk functions as dysfunctional, with the divisional risk functions reporting to group on a functional basis but not having a hard reporting line, which created a "them and us" culture. Did you agree with that?

Sir James Crosby: No. In any organisation like this there will always be tension between the risk functions and the businesses and there should be, because that is part of the constructive challenge. I would not agree that it was dysfunctional.

Q1387 Chair: In this case, the constructive challenge got a bit too constructive, didn’t it, so you sacked him?

Sir James Crosby: No.

Q1388 Baroness Kramer: He was removed in 2004.

Sir James Crosby: Perhaps I should pause there and just explain where we were. In the period, post-merger, the group risk functions reported to our finance director Mike Ellis, who also championed the group risk functions at the centre of the organisation. He did a very good job in terms of his leadership and developing the group risk functions and their clout within the organisation. Towards the end of 2004, he decided he was going to retire.

It seemed right at that stage that we should take that opportunity to give the group risk functions higher profile and create a role, at the centre, of group risk director that sat on the executive board, which had not hitherto been the case. At the time we went through a good succession planning process and decided that somebody else other than Paul Moore was better qualified to head that function. We chose the person who was closest in succession, had among the broadest range of experience and, because of their experience-admittedly in the business areas rather than the risk-and because of their standing in the organisation was very well placed to lead risk and give it clout. At that stage, in looking at the reorganisation of the risk functions and having appointed, I think, Jo Dawson to the director of risk role, we decided there was probably wasn’t within that a sensible role for Paul. In effect, he was redundant in that structure. It was after that that Paul made a series of allegations, some of which you are referring to, as a result of which a completely independent investigation was mounted, overseen by the FSA and carried out by one of the firms of accountants. It concluded there was no merit in that.

There was no way that we in any way removed Paul because he was a source of challenge. Paul was a very capable colleague in a particular area of risk, which was conduct of business risk, largely in the retail and insurance areas. When we looked at the new structure for risk, there wasn’t a role available that he was best suited to. As is often the way in these things, we parted company on the basis of redundancy.

Q1389 Baroness Kramer: Interestingly, I think you said that Mr Moore made his accusations post-departure, with the suggestion that it was an angry man’s voice, but Jo Dawson then gave evidence to the panel that sounds not too different: "It is important to note that the Group Risk function did not, under the governance framework, have the right of veto on any decision nor was it involved in the sanctioning of any individual credit decision. Risk management was, first and foremost, the responsibility of the divisional CEO…Given the advisory/oversight role afforded to Group Risk, the ability to challenge individual divisions effectively depended on the quality of relationships between the Group Risk team and the divisional CEOs and their teams. The relationship between Group Risk and the Corporate division…was probably the most challenging of these."

So, something that perhaps was the most significant risk management strategy you could have embedded into an organisation that was taking on risk on a significant number of fronts depended very much on personal relationships. It did not have institutional strength. Frankly, in your view, did you have a structural problem in the relationship between corporate group risk and divisional group risk?

Sir James Crosby: No, I don’t think we did. In terms of credit sanctioning and detail, the vast reservoir of our capability was in the corporate division. We ran a classic three-lines-of-defence model, in terms of the corporate structure. The first line of defence was inside the divisions. They had their own risk functions who-in corporate’s case, for example-would individually rate loans for sanctioning higher up. The second line of defence was broadly the group risk functions and the group risk committees, and they did review risk in the wider sense and at a macro level. They set out the policy statements and agreed them with the board, within which all the divisions had to operate, so I don’t think it’s right to say that the group risk functions did not have the opportunity to challenge. They had the opportunity to challenge through contact with the finance director, the chief executive and the board, as well as through the divisions, and through their analysis of the risks that were being taken and their stress testing of those risks, and through the policy statements that governed the way risks were taken across the organisation, which they played a principal role in developing.

Q1390 Baroness Kramer: But you have two in a row, both effectively talking about their powerlessness. Is it not true that you had big beasts, essentially, running-

Sir James Crosby: Mr Moore was not group risk director.

Q1391 Baroness Kramer: He was one level down. He reported to finance.

Sir James Crosby: He operated in the retail environment. That is important to stress.

Q1392 Baroness Kramer: Let me put it this way. You had two key players who felt powerless, and we also know in hindsight that the quality of the credit book is one that surely an effective and independent group would have been able to challenge and question. Had that line of defence worked effectively, surely we would not have had the crisis that the bank experienced, or certainly not to the same degree, in 2008. Can you not even look back now and try to identify where the weakness was in the credit structure, since that has got to be crucially important in analysing how banks need to move forward? Can you not even look back now to identify where that weakness lay?

Sir James Crosby: All I would say is that we had deep-seated expertise on the credit assessments inside the division-at a credit-specific level-and at the centre we had very strong technical specialists in terms of the macro and policy statements.

Q1393 Baroness Kramer: I am sorry, but it is just beyond me that someone who was strong would not have identified the problems. It is not as though they were unexpected. I am no spring chicken, and I am sure you are younger than I am, but surely we have both seen banking crises, one after the other, that all fell over on exactly these same three benchmarks. A credit risk department that was independent, effective and powerful would surely have been able to act.

Sir James Crosby: I cannot comment on whether a fundamentally different structure would have made such a significant difference as you are suggesting.

Chair: That it is a shame, as that is what we are being asked to think about as a Commission, but we hear your evidence.

Q1394 Mr McFadden: I want to ask you about the interaction with the FSA which Lord Turnbull raised a little while ago. How did you respond to concerns raised by the FSA commercial property review and the 2004 ARROW review that resulted in an increased capital ratio from 9% to 9.5%?

Sir James Crosby: We had a very full discussion at the board level. Part of that ARROW review was that the FSA commissioned a skilled person report by PwC into a number of areas-I think it was mostly into the corporate area and the corporate credit sanctioning area. After that report, we responded very fully in implementing the recommendations.

Q1395 Mr McFadden: Reading from FSA minutes of a discussion with Andy Hornby from the FSA in January 2004, they describe Andy Hornby as saying that you went ballistic in response to the risk mitigation plan which the FSA had been in discussion with the bank about. Why were you so resistant to the FSA raising concerns?

Sir James Crosby: I’m afraid I don’t recall that. I don’t recall what, in that discussion, Andy was referring to; I am sorry, but I don’t. The fact of the matter is that I wholeheartedly supported, month in, month out, the completion of the plan.

Q1396 Mr McFadden: Let me just read it out more fully. Andy Hornby said that James-yourself-went ballistic and raised the broader point that if the FSA were to be continually concerned about volume, they should understand the products better. The FSA responds by saying that controls need to grow at the same rate as the business. That was its core concern, wasn’t it? The growth in the business wasn’t being matched by your capacity properly to understand the risks.

Sir James Crosby: I was talking earlier, in answer to the questions Lord Turnbull raised, in that context. That was its core concern. I don’t recognise the cross-reference there, and if I did I would say so. I have no recognition of that. I was, first and foremost, supportive of the actions we needed to take. It was a legitimate challenge from the FSA and we pursued the remedial actions that arose from the skilled person report, and we pursued them to the full.

Q1397 Mr McFadden: The bank lost about £11 billion in the Irish property market. Ireland was not in itself short of banks that were willing-if I can put it at its most generous-to lend extremely liberally, with the consequence that we have all seen in property. You were a late entrant to this market, comparatively speaking. What would you say about the quality of the loans you were making in the Irish property market?

Sir James Crosby: I have not seen the comparative data-I know that subsequently the bank lost a lot of money in Ireland proportionately, relative to them, but I have not seen how it has compared with the peers, because I have not been able to differentiate between the extent to which that was a product of what happened in the market in general, and our lending. We had been there for quite a reasonable period. Some of the lending-roughly a third of it-was mortgage lending, and the next biggest tranche was in the retail-related space. I cannot comment on how that quality of lending compared with that of peers.

Q1398 Mr McFadden: But you admitted in the protracted exchange with the Chairman a little while ago that the bank was running an incompetent lending policy-lending too liberally with risk controls that did not-

Sir James Crosby: Yes, with the benefit of hindsight, the loans did not perform as well as they should have done, even in that crisis. I cannot say whether that was the case in Ireland or not.

Q1399 Mr McFadden: When you say that the loans did not perform as well as they should have, you ended up losing a colossal amount of money in this sphere-twice what RBS lost. This is not performing "not as well as it should have"; it is an absolutely catastrophic loss of money.

Sir James Crosby: I am not denying that.

Q1400 Mr McFadden: Which is being felt by the whole economy.

Sir James Crosby: Yes.

Q1401 Mr McFadden: The banking world has been rich in banking knights, but only one of them has been stripped of his knighthood: the former Sir Fred Goodwin. You have said today that you do not want to give up any of the pension or settlement that you left the bank with. Have you considered your position with regard to your own knighthood?

Sir James Crosby: When, in 2006, as I stood down from the bank, I was awarded that knighthood, it was a huge honour. It was awarded at a time when people saw the organisation as having been generally very successful. It was a huge honour in so many different ways. I am in no doubt that my reputation and my achievements will never be seen again in the same light.

Q1402 Mr McFadden: But given the broader damage of the banking crisis, which we have heard played out over the last couple of hours-I have got no candle to burn for any particular banker-and looking at this across the piece, does it seem fair that one gets stripped of a knighthood and the other banking knights carry on regardless?

Sir James Crosby: I have been very clear about how I see it, and I think that that is for others to decide, in truth. That is not any attempt to be evasive. I am completely realistic about my reputation.

Q1403 Mr McFadden: Do you understand the anger of the public who, five years on, are coping with pay freezes, benefit cuts and austerity going on year after year-we are probably going to hear on Wednesday that it has to carry on even further-when they look at the reward you kept and the damage that was done by the organisation that you led?

Sir James Crosby: I do understand that.

Q1404 Mark Garnier: When you appointed Jo Dawson as global risk director, what assessment did you make of her experience?

Sir James Crosby: I knew that I was appointing somebody who had not worked in risk functions, but I knew I was also-

Q1405 Mark Garnier: Can you remind me when that was? Was it 2004?

Sir James Crosby: I think it was at the beginning of 2005. I think there were two or three factors. The first was that this was a senior position. We were bringing in somebody to head up group risk for the first time at the executive board level, so I was looking for somebody who was in the right place in terms of succession planning in the broader sense-bringing forward somebody to that level of the organisation. I was looking for somebody who had a track record of success, and was seen as having that within the organisation-to have clout in that role-and I was looking for somebody with a breadth of experience.

Q1406 Mark Garnier: But not experience in risk itself.

Sir James Crosby: I was looking for somebody who could lead that function, and lead risk professionals and enhance the impact of those professionals.

Q1407 Mark Garnier: So these were risk professionals at the corporate side.

Sir James Crosby: No, anywhere in the group. There would be a centre of-

Q1408 Mark Garnier: But how would she know what they were saying to her, if she did not know anything about risk?

Sir James Crosby: Well, she would do, because she had worked in the corporate banking area, she had worked in the investment area and she had worked in the retail banking area. This was somebody of real experience, and with a breadth of experience.

Q1409 Mark Garnier: You have said on a number of occasions-this is something that keeps striking me every time you say it-that the wholesale funding was seen as a risk to the strategy and not as a risk to the bank. Isn’t that just looking at completely the wrong thing-and you put somebody in place who was not going to challenge that monumental misunderstanding?

Sir James Crosby: No, I don’t think so.

Q1410 Mark Garnier: Why were you focusing on the risk to the strategy? I don’t understand how you were focusing on risk to the strategy and not on the risk to the bank.

Sir James Crosby: We were focusing on the risk to the bank; it was just that we saw the wholesale funding-

Q1411 Mark Garnier: You have talked about risk and strategy three times. It is striking that you are looking at the risk to your growth strategy and not to your-

Sir James Crosby: No, we were looking at the risk to the bank, but when we talk about a risk in the context of a business plan, sometimes we are talking about risk in the broader sense and sometimes we are talking about a risk to our ability to develop the business in the way we planned. Perhaps we are not always clear about which is where-that is all.

Q1412 Mark Garnier: You talked about the risk offices in your first line of defence. What do you see as your first line of defence?

Sir James Crosby: In our organisational structure, the first line of defence was the divisional management team-the first and most important line of defence, in truth-and the risk functions that they had alongside them in their division.

Q1413 Mark Garnier: A lot of people will see that as the second line of defence: the middle-office function. You are talking about the risk managers as a middle-office function.

Sir James Crosby: But they were part of the first line of defence in this context.

Q1414 Mark Garnier: But is that a good way of having the first line of defence? The first line of defence is that your business should be getting it right. The trouble is that if you have your business relying on the middle office, they are abrogating that first line of defence to a middle office, and that is a fundamental flaw.

Sir James Crosby: Not necessarily, because I think that-for example, in the corporate credit area-we were very clear that we risk-weighted in each area separately. That went through to a corporate credit committee for appropriate sanctioning. We separated the functions and had an independence of view on individual credits from within the division.

Q1415 Mark Garnier: But how could Jo Dawson push back on the structure that you had-

Sir James Crosby: Well, she could push back on the structure or, if she had seen fit to do so, she had access to the corporate credit teams. They all sat at the executive group credit committee, and she, with her risk professionals in group risk, will have been at the heart of developing the policy formulations, within which the divisions had to operate, and overseeing the stress testing of all the various risks. The group risk functions had a really important role, in the second line of defence, in working closely with the divisions, but also working with their risk functions.

Q1416 Mark Garnier: You had spectacular growth in your loans, which we have talked about at great length. Who challenged why that was so good? Who was asking the question about whether that was due to your superior capability as a bank, or just because other banks were not exposing themselves to the areas that you were?

Sir James Crosby: I think there was always that debate about the quality of lending. But, as I said, during my time-

Q1417 Mark Garnier: But who challenged as to why it was being so successful? Who sat down, at the board level-or indeed anywhere in the bank-and said, "Why are we being so good at this?"?

Sir James Crosby: When we talked at board level about the performance of the business, we would always debate why it was that we were being successful, and ask what the reasons were for our success. In our terms, it was the continuation of what the Bank of Scotland corporate team had built and the market position they had in those markets. Once we went into the merged entity, it was the ability to operate on a slightly larger scale. That was what was different. The reason why they were successful was substantially, in our terms, the same as it had been historically.

Q1418 Mark Garnier: How long was Jo Dawson global risk director?

Sir James Crosby: I am not sure precisely, because she gave up the role and moved into insurance and investment after I left the bank. I am not precisely sure when it was, but it was not a very long period. It was a year, or a year and a half, perhaps-maybe slightly longer.

Q1419 Mark Garnier: It was then taken over by Dan Watkins.

Sir James Crosby: Yes.

Q1420 Mark Garnier: Do you know how much experience Dan Watkins had of risk?

Sir James Crosby: Dan had good experience in an investment banking and treasury background, as far as I am aware. He had a lot of experience in the retail bank.

Q1421 Mark Garnier: But nothing specifically in risk.

Sir James Crosby: Not specifically in risk, but he had experience in related areas.

Q1422 Mark Garnier: So you had two successive global risk directors who had no specific experience in risk.

Sir James Crosby: I agree it is unusual, but it was not-

Q1423 Mark Garnier: Unusual? It is bizarre.

Sir James Crosby: Yes.

Q1424 Mark Garnier: How long did he stay in that role? Do you know?

Sir James Crosby: I do not know. I am not trying to be evasive, but I was not involved in his appointment and I was not involved in any of those changes. I do not really want to be speculating.

Q1425 Mark Garnier: No, but is it not the case that they were relatively short periods and that they were actually stepping stones to greater jobs elsewhere? My point is this: is the global risk director’s job seen as a very important strategic function, or is it merely seen as a stepping stone to a job elsewhere? Were people passing through and getting a bit of experience before moving on?

Sir James Crosby: It was certainly my ambition when I created the role to give it extra profile. That was what I was doing. I was putting it on the executive board and giving the role direct access to the chief executives of the division around the table when all the issues were being debated in a way that really enhanced the position in the context of the group.

Q1426 Mark Garnier: It may have enhanced the position, but did it enhance the performance of that office?

Sir James Crosby: I was there for only a short while after I did that.

Q1427 Mark Garnier: In your opinion, did it enhance performance?

Sir James Crosby: While I was there, I believed it did, yes.

Mark Garnier: All right. Thank you.

Q1428 Chair: It has been quite a long evidence session-longer than we had planned-but I have one final question for you, Sir James. For the purposes of the approved persons regime, do you consider yourself to be a fit and proper person to run a financial company?

Sir James Crosby: I have no plans to apply to be considered as such.

Q1429 Chair: I have a list of the jobs you have at the moment in front of me, but I am just asking you that question.

Sir James Crosby: I do not expect that, if I applied, I would be approved, given my history.

Q1430 Chair: So you do not think that you are a fit and proper person to run a financial company.

Sir James Crosby: I think I am too closely associated with the problems at HBOS for that to be the case.

Chair: Thank you very much for giving evidence this afternoon. It has been long, and I am sure it has been difficult for you; it has not been easy for us to get to the bottom of all of this, and there is more work to be done. We will take a five-minute break now and recommence with a session with Andy Hornby.

Examination of Witness

Witness: Andy Hornby, Chief Executive, HBOS, 2006 to 2008, examined.

Chair: Thank you very much for coming this afternoon, Mr Hornby. It is a bit later than planned. I am going to hand straight over to David Quest.

Q1431 David Quest: Good afternoon, Mr Hornby. Just to put you in context, you were an executive director of HBOS throughout its life, from the original merger in 2001, right up until the subsequent merger with Lloyds. You were chief operating officer from July 2005.

Andy Hornby: Correct.

Q1432 David Quest: And you became group chief executive from about the middle of 2006.

Andy Hornby: Yes. I think I formally took over on 1 August 2006.

Q1433 David Quest: Were you here when Sir James Crosby was giving evidence?

Andy Hornby: I wasn’t, I’m afraid. No.

Q1434 David Quest: One of the things he said is that, although he did not formally cease being group chief executive until the middle of 2006, in effect, from the time when he announced his departure at the beginning of 2006, in practical terms the day-to-day chief executive responsibility passed to you. Do you agree with that?

Andy Hornby: I would certainly agree that it was passed over during the course of those few months in a gradual, planned way.

Q1435 David Quest: So in effect, you had chief executive responsibility more or less from the beginning of 2006.

Andy Hornby: As I said, I formally took over on 1 August, but I would certainly agree that it was an orderly handover throughout that period.

Q1436 David Quest: Before then, you were on the board throughout, so presumably, you were responsible for approving all the business plans from 2001 onwards.

Andy Hornby: Yes. As chief executive of the retail division, clearly I sat on both the executive committee and the group board.

Q1437 David Quest: Right. Can we start by looking at some numbers about where the bank ended up? If you have the big file in front of you, could you open it to tab D2? You should have a series of tables there. Can you turn to the second page of that document? You should see a box labelled, "HBOS customer loan impairments". This is a table of loan impairments that have been taken directly from the audited financial statements. They show, as you will see, the figures of £9.8 billion impaired in 2008, £18 billion of loans impaired in 2009, more than £10 billion in 2010, and more than £6 billion in 2011. In total, some £45 billion of loan impairments have been suffered as losses in the last four years. Those are truly catastrophic figures, aren’t they?

Andy Hornby: They are very poor losses, I agree.

Q1438 David Quest: They are catastrophic, aren’t they?

Andy Hornby: They are appalling losses.

Q1439 David Quest: They are so large, are they not, that had it not been for the taxpayer and Lloyds bank making a series of massive capital injections into HBOS in 2009 and 2010, HBOS would essentially have been insolvent?

Andy Hornby: I find that a very hard question to answer. Clearly, if I have understood this table correctly, the overall position of HBOS, with impairments as a percentage of loans, is, as you say, quite appalling. What I would like to point out though is that I believe that the core driver of what has created such significant impairments, which largely came from the corporate lending operations in both the UK and, to a lesser extent, overseas, was a result of the incredible closure in wholesale markets that had taken place over the previous nine to 12 months before the takeover by Lloyds at the end of 2008. The double gearing of the closing of wholesale markets, which had led, first of all, to mortgage banks such as Northern Rock in 2007 and Bradford and Bingley in 2008 getting into catastrophic funding problems, which then led on to our wholesale funding shortening consistently over the next 12 months, which then led on to the catastrophic decline in corporate banking asset values, is what caused this to happen.

Q1440 David Quest: We will come back to funding in a moment. The point I am making is that HBOS did not have sufficient capital to sustain £45 billion of losses on its loan book. Had it not been for further injections of capital, HBOS would have become insolvent.

Andy Hornby: I accept the fact that HBOS needed further capital; that is clear from the figures. I am merely saying that I think the cause of why the losses were so catastrophic and so significantly higher in corporate banking than we had seen in any of the previous cycles and the kind of things that had been stress-tested for is because it was the total closure of wholesale markets over so many months-over a year, in fact-that led to this incredible gearing effect in terms of corporate banking asset values, which is the fundamental cause of these very appalling losses.

Q1441 David Quest: If you turn back to the previous page on the same document-the first page-you will see another way of illustrating the same point. Here we have a table of how much equity was put in. I think there was £28 billion of equities being put in. The bank, in 2011, only had a book value of £22 billion. One does not need to be a particularly skilled mathematician to see that it was insolvent beforehand.

Andy Hornby: I was not in the company to know how the impairments were calculated, but from these numbers clearly the further equity injections were essential.

Q1442 David Quest: Again staying on this document, on page 3 you will see a table of how those impairments compare with HBOS’s competitors, and you will see from that table that HBOS did twice as badly in proportional terms, or worse than all its competitors.

Andy Hornby: Yes. I have already said that I completely agree that these impairments are appalling. There is no other word for them. But I think the comparison between HBOS and internationally diversified banks such as HSBC or Barclays, or banks such as Lloyds, which were much less in commercial property lending, is a very different comparison. That does not in any way detract from the fact that the losses are appalling.

The only other thing in the schedules that I want to mention-again, this does not detract from the overall message of the catastrophic nature of the losses-is that the Australian numbers are taken at a particular point in time because I believe, but I have not had a chance to talk to the people who did the analysis, that the 2008 numbers were struck at the end of 2008, so just after Bankwest was divested and sold. Bankwest was a largely retail bank in Australia, and in effect what we might call the good bank-the bank with the lowest losses-was divested whereas the corporate rump had been maintained. That aside, I utterly take the point that the comparison makes very uncomfortable reading.

Q1443 David Quest: There are various reasons why HBOS did so much worse in its loan impairments, and we shall come back to that. But one of its principal problems was that it was significantly exposed to commercial property, and in terms of the impairments that has proved to be a very significant problem for HBOS.

Andy Hornby: Yes. If you look through the annual reports for a two to three-year period you can see that typically-it did not move that much-commercial construction made up around 35% or 36% of the corporate loan book, and the corporate book made up around 25% of the total balance sheet. What is incredibly disappointing and I believe goes back to the unforeseen and unprecedented total closure of wholesale markets is that the asset value deterioration that occurred in corporate markets, particularly commercial property markets, was absolutely phenomenally high. If you compare it with previous cycles in the early ‘80s and early ‘90s, the gap between what happened in commercial property and residential property in the cycle was extraordinary. That is why, bluntly, the maths is simple, and that is why HBOS’s losses look particularly poor against the likes of Barclays and HSBC.

Q1444 David Quest: One of the reasons I am raising this is that you previously gave evidence to the Treasury Select Committee and the banking crisis Committee. You will find your written evidence on that at tab E2, which is a joint memorandum you gave with Lord Stevenson. If you turn to paragraph 4 on page EV431, you will see at paragraph 4, that you say, "In summary the loss of liquidity in the market that started in 2007…was the overriding reason for the strategic problems encountered by HBOS." You mention exposure to the commercial property market, but it is very much downplayed because you say, "Two other issues while themselves neither of them the cause of HBOS’ strategic problems have aggravated them." Under the second bullet point you refer to, "exposure to…sectors of the UK commercial property market." In truth, that was absolutely at the heart of HBOS’s problems, wasn’t it?

Andy Hornby: I have already agreed with you in that I have said that I think the primary impact on HBOS of the seizure of wholesale markets, which, clearly, I am sure you want to talk to about in great detail in a while, was the impact it had in terms of our commercial property book. And the impact it had on commercial property in comparison to the impact it had on residential property and other asset classes was vastly higher in this cycle.

My personal view, for what it’s worth, as to why that happened-it is because most of the suppliers of finance to commercial property in the UK market through this cycle were wholesale-funded banks-very easy to see that with the wisdom of hindsight-HBOS, RBS, all the major Irish banks. So the largest players-Barclays to a lesser extent-in this space were reliant on wholesale funding.

When, from August 2007 onwards, wholesale funding therefore started to cease and, from September 2008 onwards, when Lehman’s went, it actually stopped entirely, the double gearing impact from the fact that all the housing finance supply-commercial property, I should say: commercial property finance supply dried up, along with the normal corrections that would take place in asset cycles-was catastrophic, and I think you see that in all the banks that had heavy exposure to commercial property.

Our numbers are here for all to see. I repeat what I said at the Treasury Select Committee, when I gave heartfelt apologies for what happened at HBOS. I repeat that. But I do believe that that was the core driver.

Q1445 David Quest: Apart from the exposure to commercial property, other features of HBOS’s lending, as I think you recognise in your statement, were a concentration in lower credit-rated exposures-

Andy Hornby: In corporate lending.

Q1446 David Quest: Yes.

Andy Hornby: Can we just be clear on that, please? Corporate lending was 25% of the HBOS balance sheet, and in each of these answers-and whilst you are rightly focusing on corporate lending, because that is where the bulk of HBOS’s losses occurred, if you look back through FSA reviews, our own business plans, and everything, from 03 through to 07, many of the times there were other parts of the business that were causing us more concern in terms of the risk profile than corporate lending. Clearly, in retrospect, that was wrong. But yes, within the corporate book, to answer your question specifically, we had a higher percentage of lower credit.

Q1447 David Quest: And you had a large number of single-name borrowers and you were exposed to highly leveraged transactions.

Andy Hornby: That is all correct identification of features within the corporate book.

Q1448 David Quest: And what you say in your statement is that, with the benefit of hindsight, those particular features made the book particularly vulnerable to an economic downturn.

Andy Hornby: Can I just clarify that further? With the benefit of hindsight, clearly all those features made us vulnerable to the significant losses that you had there. With a particular benefit of hindsight, our reliance on wholesale funding in commercial property and leveraged segments where the other suppliers were also reliant on wholesale funding was a major strategic weakness.

Q1449 David Quest: Like you said, it should not require the benefit of hindsight to see that, if you have a relatively high-risk book concentrated on commercial property and concentrated on single-name borrowers, it is going to be particularly vulnerable to an economic downturn.

Andy Hornby: Yes, but again, to try to put that in some kind of context, for example, our largest book was residential property. Clearly, the first thing-the biggest, because it was by a major factor-was that 50% of our assets were in residential mortgages, residential property; that was the most specific concern in terms of stress testing. Likewise, we had a large life assurance business, with a very high risk of equity markets going into significant deterioration. The capital impacts of our life book was a very major concern in terms of stress testing.

I am not trying to duck away from the blame-I have already said that the impacts of the corporate lending asset decline were catastrophic-but I am just trying to put it in context, alongside all the other risks that were being looked at in a bank this size.

Q1450 David Quest: Are you suggesting, then, that insufficient attention was paid to corporate, because of its relative size in the organisation?

Andy Hornby: No, I think that would be putting it too strongly. But what I am saying is, inevitably, in a large bank, when you have granular detail about so many issues simultaneously-and the fact that I do not believe that, even though we stress tested, as you will see from our business plans, for one in 25-year downturns, consistently across all of our books, we would have stress tested for corporate lending markets literally seizing on the back of the fact that wholesale markets had dried up. Just to put a bit of colour on that, Phil Hodkinson, who was the Finance Director in the first year of my tenure-it changed to Mike Ellis in my second year-pointed out in his submission that we regularly stress tested wholesale markets for two downgrades in terms of our credit rating-two notches down, which seemed like a very severe test.

Our wholesale funding was split pretty evenly between UK sterling, euros and US dollars. We stress tested regularly for one of those markets coming into serious difficulty and the fact that our funding base would therefore be under severe pressure for many months. I do not, to the best of my recollection-and it certainly wouldn’t have been included in the one-in-25-year stress testing that we were doing for the FSA and for our business plans-recall stress testing for all long-ended markets closing for a year and then for the entire market, except for overnight markets, seizing entirely, which is exactly what happened. And that is why I believe the impact on the corporate book was so catastrophic.

Q1451 David Quest: Bank of Scotland has been in existence for more than 300 years. Do you not think one-in-25 years is perhaps not sufficiently prudent?

Andy Hornby: You have asked an incredibly important question. Over the last five years, I have spent a lot of time trying to rationalise a lot of what has happened. Even if you look back to the 1930s, I don’t believe the wholesale markets totally froze then to the degree that they did in 2007, and particularly in 2008. I believe-I cannot prove it, but it seems to me an inevitable consequence, as the vast majority of the suppliers of finance to commercial property in the UK were wholesale funded-that this spiral was therefore unprecedented.

Q1452 David Quest: So you were really in the position where you were exposed at both ends in the sense that your borrowers were exposed to wholesale funding risks and you as HBOS were exposed to them because that’s how you funded your own business?

Andy Hornby: I think that the huge lesson of the financial crisis is that all major banks around the world who were relying on wholesale funding to a significant degree to buy the balance sheets had that double gearing. You can look at almost any major bank that came into severe difficulty with their funding and see that that inevitably led on to asset deterioration. It happened at different speeds. Take, for example, Northern Rock and Bradford & Bingley, who were clearly the first to run out of funding: their asset quality deterioration would have been less advanced at that stage because the housing market did not show nearly as major a downturn as commercial property. I believe the reason for that is that many other players providing housing finance were not so reliant on wholesale funding. Whereas, in the commercial markets, there were just not enough players to take up the slack and the impact was catastrophic.

Q1453 David Quest: The double gearing you referred to-again HBOS was more exposed than its competitors at both ends of that, because it had a higher requirement for wholesale funding and it also had a more concentrated commercial loan book?

Andy Hornby: Yes. This is again a very painful lesson to look at because so much work was done over so many years, under both my predecessor and me, to keep broadening our wholesale funding base and trying to de-risk it. It may look spurious now, but at the time when we set down the road to try to get 50% of our wholesale funding more than one year-and got there by about 2006-07-that seemed like a very tough target.

It may seem incredible now, but at that stage funding of more than one year in wholesale markets was seen as safer than liquid deposits. By definition, liquid deposits can be asked for overnight and customers can withdraw a liquid deposit instantly. As it proved, that was not true, because what happened when all long-term markets dried up-and they all did simultaneously; that is what made this unique-is that the length of that long-term funding kept shortening. Obviously, as the long-term funding rolled off the balance sheet, it was having to be replaced by much shorter-term funding, and therein lies the problem for all the major banks that were wholesale-funded through this period.

Q1454 David Quest: Can we look at the planning process which resulted in this? You mentioned in your statement that there was a process of rolling five-year business plans. I’d like to look with you at the one for 2007 to 2011, which you will find at tab G4. You became chief executive in mid-2006, so this would presumably have been the first plan while you were chief executive.

Andy Hornby: That is correct and in fact, I did two plans. Myself and the finance director would have presented this plan to the board, and the following year’s plan. I had two plans in my tenure; this one and 2008.

Q1455 David Quest: This one is entitled, "Six Strategies to Success", which is slightly unfortunate given what happened.

You say in your statement that, although there was a plan for year-on-year growth since 2001, you were targeting slower growth from 2005-2006 onwards. You also say in your statement that, from about 2006, the economy was showing signs of deterioration. However, when we look at the plan, we see that it says-for example, on page 1 of the plan under the heading "Executive summary", at the bottom of the page under the heading "Growing the UK Franchise" that, "Overall our plan targets average asset growth at 8% per annum in the UK, slightly faster than envisaged this time last year." It looks as if, even for the 2007 period, you were planning not just continued growth, but actually faster growth.

Andy Hornby: I have tried to look back through what documents I have available, and I think there was an increase of around 0.5% in the planned asset growth in the UK in 07, versus what had been envisaged when the 06 plan had been written.

Q1456 David Quest: But this doesn’t indicate that you are pulling back on growth, does it? It indicates you are increasing it.

Andy Hornby: No, but I think two points: first of all, it doesn’t take away from the generic point you just made about the way that the pace of growth-I think if you look at compound growth rates from 2001 to 2004, the company grew its asset base by around 16% per annum. From 2005 to 2007 it was planning for 9% to 10% per annum. I accept the fact that it appears in the roundings there may be a 0.5% increase there, which takes it up to 8% in the UK, but the overall shape of the 07 plan was incredibly similar to the 06 plan with asset growth and deposit growth almost identical. On page 23 of the plan, you can see total asset growth of 11% versus deposit growth of 10%, and the asset growth, with roundings, was almost identical to that that had been achieved in 06. So I accept the point that we were not signalling here-as with the glorious benefit of hindsight we certainly should have been-a significant slow-down, but I do not accept the fact that we were intimating any acceleration. It certainly wasn’t what we were talking to public markets about.

Q1457 David Quest: You were forecasting here on page 23, as you pointed out, average growth of 10% or 11% for five or six years in the future. That is a pretty ambitious target in circumstances where, as you say, there were already signs of economic deterioration.

Andy Hornby: Yes, and I am very happy to come and discuss the details after. The key shape of that is UK asset growth in around the 8% to 8.5% range. In retail, which is the business that I had been responsible for, we pulled back quite considerably in terms of asset growth, with it being typically 5% to 6% there, whereas international asset growth was running at around the 20% range. That’s what gets you to an average around 10% or 11%.

Q1458 David Quest: Yes, what you were doing is making up for more moderate growth in retail by greater growth in corporate, and even greater growth in international.

Andy Hornby: The corporate asset growth, with respect, was very similar to what had been achieved previously. You can see from 05 to 06 and 06 to 07 it is a fairly similar percentage rate.

Q1459 David Quest: Do you recall what growth you were forecasting in international?

Andy Hornby: You can see the international growth here.

Q1460 David Quest: The figures you have put elsewhere in the report are 23% per annum in the international business. That is an incredibly aggressive growth rate.

Andy Hornby: Correct, and I have already said that I think that the international figures that are in the schedule are slightly misleading. I accept the fact that with the benefit of hindsight having grown the Irish business into what proved to be a catastrophic Irish recession, led to appalling losses. In actual fact, in Australia there were two elements to the business: the Bankwest retail bank, which performed very well through the downturn and the corporate lending book that hit very similar problems-not as severe as the UK and Ireland-but nevertheless hit issues. But my point, to be very specific, because I am not avoiding your question, is that the asset growth that was being planned in the UK was broadly the same as has been achieved from 05 through 06.

Q1461 David Quest: There is no sense of it slackening off?

Andy Hornby: No, and with the benefit of hindsight we clearly should have slowed corporate quicker. Interestingly, our growth, from memory, and I have not been able to look through a whole load of brokers notes to achieve this, the kind of asset growth and deposit growth that we were forecasting, particularly asset growth, was if anything at the lower end of many of our competitors at the time.

Q1462 David Quest: Going back for a moment to international, one of the things you say in your statement about that as a reason for expanding in Ireland and Australia was that it was seen as a strategic weakness within HBOS that it didn’t have international exposure-that is how you put it.

Andy Hornby: Yes, let me comment on that. If we go back to 04, 05, 06 and even the first half of 07, if you read analysts’ reports and look at shareholder feedback on HBOS, the biggest positive that was being put was, if you believe in resilience, particularly of residential property markets, that there was a belief in resilience of asset quality. Clearly, I will not go back over what I have just said about commercial property, which proved not to have been recognised by many people. The biggest negative was by people who either saw the UK as ex-growth, or saw the UK as having genuine potential for recession, where we clearly had a vastly higher exposure to the UK than Barclays, RBS, HSBC, to name three competitors.

Q1463 David Quest: As it turned out, the strategic weakness was being in the international markets, not not being in them. You ended up suffering catastrophic losses in those markets.

Andy Hornby: I accept part of that, but only part of it. I accept the fact that clearly expanding into Ireland in any meaningful way, given what happened to the Irish economy and particularly to commercial property, was a mistake. I think growing the retail part of Australia was actually a very sensible thing to be doing, or attempt to be doing. I do actually mention in my submission that one of the regrets is that the process of growing retail banking, which is obviously of much lower risk and in an economy like Australia that has survived well, was a good thing to do. It was difficult to grow as quickly in retail banking as in corporate banking because it takes so much longer to build franchise-built deposit bases and build scale. I do think that the attempt to build a bigger retail banking business in Australia was the correct thing to do. I am not in any way decrying the fact that the commercial property book in Ireland has caused losses.

Q1464 David Quest: You have that table on page 23 of the plan, the forecast balance sheet. The other thing we see from this balance sheet as well as the growth in assets over time is the growth in your funding requirement, which is the penultimate line, which is forecast to grow from £156 billion in 2006 to £260 billion in 2011. As you say, by this time, it had been recognised for some years that reliance on wholesale funding was a particular issue for HBOS, and yet here you are projecting to continue increasing your reliance on funding well into the future. I appreciate what you have said in your statement about how you sought to address the funding requirement, but did it ever occur to anyone to think that one way of addressing it would be simply to reduce the reliance on it, rather than fiddling around with how you got it?

Andy Hornby: Two points on that. Your maths is perfectly right. Even if we were to have halved the asset growth, because, as you can see from this, the absolute amount of assets is higher than deposits, so even if you were growing assets by, say, 6% rather than 10% a year, the funding requirement was going to go up. That is a palpable piece of maths. That was the case, and remains the case now for any bank in the world that has assets that are higher than deposits and therefore is funding a significant part of its liabilities through wholesale funding.

All I can say in mitigation-I would like to expand a little bit if I may, Mr Quest, on what we were saying earlier in terms of stress testing-is that the funding liquidity team was responsible for doing two things: first, to broaden the base of our wholesale funding capability. You saw, for example, that around 2004-05, to try to help our retail funding side, we started issuing covered bonds as well as securitisation, which is a different asset cover. You saw that, throughout this period of the plans, we tried to diversify our reliance on UK sterling until we got to a stage where we were pretty evenly matched across currencies-a third sterling, a third euros and a third US dollars.

I cannot stress enough that those two core stress tests that the finance director and the liquidity team were putting through were perceived to be very severe-one-in-25-year or one-in-30-year-shocks in terms of wholesale funding. I bitterly regret this. I wish that we-among others, but particularly we-had foreseen the possibility of wholesale markets closing for a full year. If they had closed for a full year though, even if there had been no asset growth-I am not in any way denying your points about the level of impairments that arose-the funding position would have become intolerable, because the sheer maturing of the wholesale funding was already on the book, and as that matured, it had to be refinanced. There was not the market out there to refinance it.

I would like to point to Northern Rock and Bradford and Bingley as examples. They were only in residential mortgages. They had no other markets. There was no fear that there were in commercial property or international markets. They ran out of funding because as soon as the securitisation markets shut on them, there was no way that they could refinance six, nine or 12 months out what was rolling off the balance sheet, because their assets were bigger than their deposits. Sadly, that is what happened.

Q1465 David Quest: Finally on this document, if you go to page 72, you see the risk very clearly identified under liquidity risk. It says: "Our balance sheet is heavily reliant on wholesale funding to fund customer lending, and the key risk is if we are unable, for whatever reason, to access wholesale markets for a prolonged period of time." It seems, with hindsight, rather prescient.

Andy Hornby: It is. I wish that mine and many people’s hindsight had stretched to that being as long as a year. It had never happened before, and it did happen.

Q1466 David Quest: Staying on corporate for a moment, can I turn to the FSA final notice on the Bank of Scotland, which is a document that I assume you have read? You will find that in tab F1. As we have understood it from other witnesses who have given testimony to this Commission, the way that the challenge process works at divisions, at least at the initial stage, is that plans would be presented by the division and challenged by the chief executive and the financial director.

Andy Hornby: That is correct. Obviously, I saw two sides of this for many years. I was presenting the retail plan to the executive committee and the group finance director in particular. The group finance director tended to lead the planning process and would be in charge of the core challenge process. When it came to the final pulling together of all the plans that we discussed around the executive committee table, the finance director and the chief executive would debate it, and then it would be presented in full to the board. The final stage would be a consolidated presentation of the plan.

Q1467 David Quest: So you were closely involved with the challenge of the corporate plans. You say in your statement that the board was well informed of core strategies, and as far as you are concerned, it was a transparent process.

Andy Hornby: I believe so. There is only one caveat to that. When you are a business the size of HBOS, any summary plan presentation to non-executives on a board clearly has to summarise things. You just used the example of the plan. You have seen the level of detail that is in there. Even in what is typically an 80 to 90 page document, there is a level of detail, and you could have gone even further. But with that caveat, yes.

Q1468 David Quest: But when you look at the FSA final notice, at the beginning of paragraph 2.5, they make a series of very serious criticisms about the corporate portfolio. In paragraph 2.7, they make a whole series of criticisms about the control framework and the distribution framework and, in 2.8, the culture of corporate. Now, you were the chief executive at the time; you saw the corporate plans and the board saw the plans. If the FSA is right, how was this allowed to happen without you and the rest of the board appreciating it?

Andy Hornby: Three things. I believe that the head of corporate is a man of great integrity. I did not perceive that there were major failings within the risk management framework in the way the FSA set out. I am not in any way challenging their findings, I am just saying that we-and this was my first year of two years as group CEO-were assessing every division. There are five divisions, as you have already said. International, you would look at particularly carefully because that was the area in which we were growing most strongly. Retail you would look at particularly carefully because that was by far the largest division in the business. Insurance and investment you would look at particularly carefully because we were worried about equity markets. So within all the confines of the amount of time and the amount of detail that you have to look within each division, I did not perceive these control framework failures.

Secondly, I believed that the corporate governance structure would have seen this type of weakness. To be clear for people who have not sat through the previous witness sessions that you have done, HBOS had a set of divisional risk control committees. Each of our divisions-retail, corporate, insurance and investment, treasury and asset management-had its own risk committee, which was sat on by the executive team from that division, the divisional risk teams and representatives of both group risk and internal audit. It was also chaired by a non-executive director from the main board, not by anyone connected with the executive. You also had a second non-executive director sat on that board. So two non-executive directors sat on every single one of our five risk control committees.

Last, but by no means least, the chair of those committees, which as I have already said were non-executive directors, had constant access up to the chair of the audit committee because ultimately those risk committees were responsible to the audit committee, not to executive management.

These were highly detailed committees. I remember when I was retail CEO the level of detail that was put in to the credit trends, regulatory risk trends, operational risk trends. I would have expected that structure to seen some of these failures that are outlined in this report. Rather than picking them off point by point, that is my call.

Having taken over as group CEO, I relied very much on the fact that group risk people attended each of those divisional committees and that non-executive directors chaired them. I welcomed the fact that they went straight through to the audit committee chairman, because I knew that there would be no way, if there were issues coming out at divisional level, that they would not get voiced immediately-not with a time delay, but immediately through to what I would consider the right corporate governance route. That is not an excuse. I am just saying that-given the antennae and all the different things you look at as a group CEO, plus all your external market responsibilities and the amount of external work-that governance cycle was the core route of control within each of the compliance cultures within the division. Clearly, the FSA did not agree that we managed to hit on issues or this report would not read as it does.

Q1469 David Quest: Given the supposed sophistication of the structure you have just described and all the various checks and balances, it seems all the more surprising that none of those points were picked up.

Andy Hornby: It is surprising. Ever since this report has been written, I have spent many a night re-reading it. I would say that, particularly having been retail CEO for five years, I felt under intense scrutiny by those retail risk committees, not just because they were chaired by non-executive directors, which in itself is a good control mechanism, but because they were always attended by my head of retail risk team, and also group risk and group internal audit, and therefore all the trends that we were analysing were having four sets of eyes, if you like: divisional management, divisional risk, group risk and non-executive directors. I am surprised, therefore, that this kind of weakness in the control environment that the FSA very clearly articulate was able to happen.

Q1470 David Quest: We know of course that only one individual was personally sanctioned, but, from what you are saying, it sounds as if in reality there was a collective failure of management.

Andy Hornby: I think that this report reads as it does. Certainly, when you read it, you think how can that very clear corporate governance structure have not got greater granularity on some of the risks that were running within one of our divisions. I wish I had a perfect answer for you. I do not believe-I have asked myself this question many times-that the governance structure itself was wrong. It seems eminently logical to have non-executives getting good insight into individual divisions in such a complex company. If you do not have certain non-execs seeing within the certain division in more detail, it is very difficult to see how you would solve it.

Secondly, on the overall planning of where risk was being taken, we took many decisions over the period of 2006 to 2008, where it felt like we were de-risking the business. I will give you two or three examples. We pulled back considerably on unsecured lending and specialist mortgages in 2006 in retail. We thought a recessionary environment could come and unemployment would increase. You can see in our plans that we deliberately decreased our unsecured lending.

In 2006, we sold our business called Drive in the US. Drive is an auto-leasing business, largely towards the more sub-prime end of the auto-leasing market. Thank goodness we did sell it. In 2006, it felt like a de-risking process to do. I hope I have articulated it clearly. I do not believe we properly foresaw the inter-linkage between wholesale funding markets and corporate lending. That was the flaw, because the double gearing was colossal. I think that that is what runs through all this.

Q1471 David Quest: Do you think perhaps an explanation of the failure by any of the people in the structure to see these risks was that, outside the corporate international divisions themselves, there was no one at a senior level of management or on the board who was a corporate banker?

Andy Hornby: Let us go through the make-up of the board, because, again, it is a question I have asked myself many times. When I took over in summer ’06, I was very aware that I was not a lifelong banker. I had been in banking since 1999, I had run a very complex retail bank for six or seven years, and I believed I had a good grasp of retail banking, but I clearly was not a lifelong corporate banker. I was always very aware of that, and I took three or four very clear decisions that were driven by my lack of corporate banking experience in particular, and to a lesser extent my lack of life assurance.

The first was to ensure that both corporate banking and international were run by lifelong bankers. The head of international, Colin Matthew, the head of corporate, Peter Cummings, and, indeed, the head of corporate’s predecessor, George Mitchell, were lifelong, 30-year bankers. They were lifelong corporate bankers through four cycles. They had been through the ’70s cycle, the ’80s cycle and the ’90s cycle. These were lifelong corporate bankers.

Likewise, I was at pains to ensure that was the case with Phil Hodkinson, who was my first finance director and had very strong insurance and investment experience, because he had been in life assurance all his career at Zurich before coming to HBOS. Lastly, I very deliberately got Mike Ellis back. He had retired from HBOS in 2004, I think. I apologise if that date is wrong-I have not checked it, but I think he retired about three years after the merger. He was a lifelong retail banker, and he was absolutely steeped in the old Halifax business. So I very deliberately felt that the divisional team covered each base, in every case, with 30 years’ experience in those respective sectors.

On the non-executive side, I took enormous comfort-I trusted him implicitly as a man who was hugely conscientious-from the fact that Tony Hobson, the chairman of the audit committee, had been a finance director Legal & General for approximately 10 years, I believe, and had known HBOS since 2001, because he was on the board from its inception. That was important to me as group CEO, because I felt that there was continuity there, and that he would understand the different pace at which the business had evolved.

I also remember that we had John Mack on the board in the later years, and he had been treasurer in Bank of America, one of the largest banks in the world. He had a huge range of experience, and I thought it was terrific that we got John. For clarity, he is not the same John Mack who ran Morgan Stanley; he had been treasurer at Bank of America. It is hard to see that the lack of experience was a core driver to the issues that arose.

The last point I would make is that even below the CEO of each of those divisions, the vast majority in the teams that reported to them were lifelong bankers. For example, if you looked across the corporate board, you would see that that entire group had been in corporate banking-not just banking, but corporate banking-for 25 or 30 years.

Q1472 David Quest: You have described that; however, the problem we are suggesting is not lack of experience within the divisions, but lack of challenge outside them.

Andy Hornby: I have sat on many boards, both as an executive and non-executive director. I can genuinely say that I felt the challenge from non-execs at HBOS was high. In my five-year tenure as a divisional CEO or in my two-year tenure as CEO, I did not feel a lack of challenge. I did not feel a lack of challenge from non-execs as a divisional CEO, and I did not feel a lack of challenge from the chairman or deputy chairman in the two years after I had taken over as CEO.

Q1473 Chair: But like the other banks, if there was challenge, it was of the wrong sort, because they all got it wrong.

Andy Hornby: I am not saying that everyone got it wrong, Mr Tyrie; I am saying that, as I have put very clearly in my written submission and as I hope I have made clear again today, we clearly did not prophesise the degree of wholesale market seizure. In particular, we did not see the impact that that would have on our corporate book.

Q1474 Lord Turnbull: To finish on the question of challenge, as I understood it, loans over £75 million needed to be signed off by another executive director. What commonly happened was that Colin Matthew signed off Peter Cummings’s loans and Peter Cummings signed off and Colin Matthew’s loans. I wonder whether that illustrates the point that Mr Quest made that there was not enough challenge outside those two. You had those two on the board, but they were in effect running the same kind of business.

Andy Hornby: It is a really good question. That is something that went through different iterations. I cannot remember the time of the different changes, but your fundamental structure is right. Small loans could be approved in division; large loans had to go to group; and very large loans had to be signed off by another executive director. There were stages-and that was questioned whether that was a good or bad idea-when non-executive directors had to sign off the very large loans as well.

At one stage, it was debated that that was not a good thing, ironically, because it was seen that people have specific knowledge to challenge it at an individual loan. What cannot be denied is that, despite those very rigorous rules as to the size of loans that had to be signed off by another director and the size of loans that had to have board approval, the commercial book delivered the results it did.

Q1475 Lord Turnbull: Can I come back to the business model? You were in at the start as the CEO of the largest division. In your evidence you said: "The merger appeared to provide a marriage of Halifax’s capital strength and liquidity strength with Bank of Scotland’s Corporate banking credentials." I wonder whether that statement is correct. Undoubtedly, Halifax brought capital strength, but it was also a bank that had a large amount of wholesale funding. When you put the two together you had an even bigger wholesale fund in the game.

Andy Hornby: Yes. I cannot remember the precise pre-merger figures, but you are right that, although Halifax funded itself largely through deposit base and certainly the percentage of the asset balance sheet that was funded through liquid deposits was vastly higher in Halifax than the Bank of Scotland, it was still nevertheless was using wholesale markets. I think that the wholesale markets that Halifax pre-merger tended to use were quite vanilla, straightforward securitisation models and therefore relatively straightforward.

Where you are right, Lord Turnbull, is because Halifax’s asset base is very large-it is the largest mortgage bank-even if you had only 80% of your book was funded through deposits, you still had a significant cash amount that needed funding through wholesale funding. Nevertheless, the Bank of Scotland was vastly more dependent on wholesale funding for a percentage of its book. That simply came from the fact that the Bank of Scotland only had branches north of the border and therefore did not have a liquid deposit base.

Q1476 Lord Turnbull: Let me look at the implications of this for the total business model. You had aggressive plans to expand corporate lending, using this capital strength from the other side of the house; you had plans to expand international, though that may have come a bit later; the bank expanded its treasury operations into what I would call fancy finance; and it expanded retail, not so much in the standard mortgages, but into specialised mortgages-self-certification and buy-to-let. On all fronts on the asset side it was an ambitious bank, possibly even an aggressive bank. It then combined it with what I would contend was a weak funding mechanism. We heard from James Crosby, who used the phrase that this merger was "predicated on synergies", but when it comes to risks-I think you have more or less confirmed this in the evidence you have given already-you have feedback mechanisms between asset prices and liquidity, and if one starts to go bad the other starts to go bad. So instead of producing diversification by bringing this thing together, you start to compound risks rather than diversify them. This seemed to me to be the fundamental failure of the business model.

Andy Hornby: Were the risks compounded? It is such a hard question, and one that I have asked myself many times. What would happen to the two individual businesses if they had still been separate when the credit crunch hit? I think that is the only way I can answer your question, and it is a very good question. It would all have depended. If you take Halifax, first of all, the unpalatable truth is that mortgage banks were the first set of banks to come under the most extreme funding pressure. Obviously, Northern Rock was the first to go in September ’07; from memory-please correct me if the date is wrong-Alliance and Leicester sold themselves to Santander that year, which was obviously a shrewd thing to do, given the funding pressure that monoline mortgage banks were coming under; and Bradford & Bingley ran out of funding the following summer, 2008.

I wish I had a crystal ball. If Halifax had been stand-alone and had just been funding a largely residential mortgage book, would it have come under the same intense pressure at the same pace as the smaller monoline mortgage banks did? It is a hypothetical question. I suspect the maths would have brought it under pressure, because the markets did basically close in entirety, and therefore any quantum of wholesale funding at the long end was shortening.

Q1477 Lord Turnbull: The impairments on the mortgage side were quite large-I would guess £2 billion to £3 billion-but they were probably not enough to bring down something as big as Halifax.

Andy Hornby: No.

Q1478 Lord Turnbull: One thing that is absolutely clear is that BOS could not have gone on this binge without the backing that this merger gave it. That is the fundamental flaw in the merger strategy.

Andy Hornby: Clearly, with the glorious benefit of hindsight, if what was going to happen to wholesale markets had been foreseen, we would not have grown the corporate business in the way it was growing; that clearly is palpably the case. To be fair to everybody involved, a number of decisions were taken to try to deal with it. For example, in 2002, I think, we came under intense criticism for a capital rating that was seen as over-conservative at the time. Mike Ellis was finance director at that stage, and he pushed very, very hard on all of us in the business to accept the short-term impact on profits that was a result of the elongating of wholesale funding, because it is obvious that long-term wholesale funding is much more expensive than short-term funding. All of that was done and was being looked at, but no one was predicting, and certainly no one was stress testing for, complete closure of the markets.

Q1479 Lord Turnbull: Numerous people giving evidence on behalf of HBOS have propounded what I would call the "innocent victim" thesis: that it was a bank doing well-this is particularly acute in Lord Stevenson’s comments and the note that you put in together in ’09-but you were overwhelmed by the financial crisis. I think we have established enough that the quality of lending was such that it set you up-you stuck your chin out and you were absolutely there for the taking-because of the structure that you had adopted, so when it came, it hit you much harder than it hit anyone else.

Andy Hornby: I have already said, Lord Turnbull, that I think that the interrelation between wholesale funding and its being the core source of funds for nearly all the major players in these corporate banking markets in which we operated meant that what you said is palpably true. When wholesale markets dried up, that double gearing kicked in.

Q1480 Lord Turnbull: That is not quite what I was saying. What I was saying is that HBOS was particularly vulnerable as a result of the structure, and suffered disproportionate damage.

Andy Hornby: If Halifax had been stand-alone, you are definitely right that the impairments would have been tiny in comparison with the numbers we looked at the start of this interview, but I still think that the funding pressure would have been significant because it would have taken very significant deposit growth over that period-almost unachievable in the kind of climate that had taken place-for there to have been no funding requirement.

Q1481 Lord Turnbull: The phrase used most frequently in the gathering of this evidence is "with the benefit of hindsight". My contention is that the warning signs were there, and had been there right from the beginning. You had a letter from the FSA in December 2002 that talked about the problem of letting growth run ahead of the risk infrastructure. You then had a spat with the FSA in December ’03 and ’04, on which-he probably regrets it now-the head of corporate lending pushed back very aggressively and described it as "very unfair". People had identified, right at the beginning of this organisation, the two weaknesses that contributed to its downfall: heavy dependence on wholesale funding and the credit process and quality.

Andy Hornby: Apologies for the fact that I-you are asking a question eight or nine years after the event, but I do remember quite a lot about that process. From memory, there were three particular issues that the FSA picked up on-four in total, but three were division-based-of which one was corporate lending and the credit processes that they described as "atypical", I think. The second was sales culture and incentivisation within retail, which was the division that I was running and I will come on to how we tackled that. The third was the potential capital risk and more financial risk that could occur within insurance and investment. The last one-I slightly separated it for a reason-was an overall view of the way that group risk management worked. There were three to four separate work streams.

You are right that that was a major warning Again from memory, we put together extraordinarily detailed work plans. I remember working on the retail risk mitigation programme for around nine months, working very closely with Mike Ellis, who at that stage was not only group finance director but responsible for group risk-the group risk director reported to him. We pulled together a programme that we talked about with the FSA not just at the end of the discussion, but continuously as we tried to pull together action plans; and I know the same thing was going on within corporate and within insurance and investment. It was at the end of that year that the capital requirements from the FSA were relaxed back down, because they believed that-

Q1482 Lord Turnbull: This was a catastrophic mistake by the regulator.

Andy Hornby: I am not criticising the regulator for that-I am clear on that. I am just saying that the plans were really rigorous, and that is what got us-

Q1483 Lord Turnbull: You hit on this mystery that, having put the pressure on you,-you have this section 166 examination-by December, you made your peace with the FSA and they reversed the surcharge on the capital ratio. By the time you get to ’06, when you are chief executive, as far as I can see, most of the discussion about risk and risk management is all about whether your Basel II model is good enough to get a waiver. You have mentioned stress testing several times. To me, all this looks like a diversion into the world of technicalities, taking your attention away from what was staring you in the face-I will come to that in a minute-which was some of the major risks that were going on in corporate.

Andy Hornby: When I look back at that period-the second half of 2006 and the first half of 2007-you are absolutely factually correct, Lord Turnbull, that I cannot stress enough how many hours went into credit modelling and the overall frameworks that had to be pulled together to get Basel II approval. I notice that you have included in the pack here the letter from December ’07, I think it was, when, in effect, they are giving this final confirmation of capital requirements and so on that came from that process. It was an extraordinarily complicated process; it was particularly complicated for a bank like HBOS, whereby we had the largest residential property book, which needed to be stress tested and modelled. Even within residential property, there were different types, such as buy-to-let, self-certified, as well as mainstream residential property.

Q1484 Lord Turnbull: Was this not just a waste of time, given what we now think about Basel II, but actually damaging, because it diverted you from the blindingly obvious? If you go to tab G12, this is a schedule of corporate facilities over £75 million-that is the £75 million over which cross-approval was needed. These are lending facilities offered to people who are not major plcs with huge balance sheets; they are facilities offered, in the main, to entrepreneurs of various kinds running property and property loan-related businesses-hotels, housing developments, health clubs, public houses and bars and so on. There are 17 of them over £500,000 and two of them are over £2 million. The idea that you are lending £2.9 billion to a single credit, which is not a major corporate, I just find astonishing. If, instead of fussing around with the stress testing and the models and the procedures that all went around it, people had just looked at this every week, they must have come to a different conclusion.

Andy Hornby: I accept the fact that in order for, in particular, the corporate risk team to model everything for Basel II, it took-I am guessing; please do not hold me accountable for dates, because it was a long time ago-close to two and a half years of the divisional risk team’s modelling capability from the inception of the Basel II concepts to the final granting of the capital requirements. So of course, that was a huge distraction.

Q1485 Chair: So it seems that the ability to identify risk is in inverse proportion to the amount of work put in to try to find it.

Andy Hornby: I have been incredibly clear, I hope, that I think, as I say in my written submission, that we missed the really big piece, which was the correlation of wholesale finding with-

Q1486 Lord Turnbull: I hope you have read Andy Haldane’s essay, "The dog and the frisbee," because it tells you exactly what went wrong through this obsession with the model. It is still going on, actually.

I have one more thing-this is a tease really. On 1 August 2008, you wrote to the managing director of retail markets suggesting that the FSA was being too conservative, and you said, "Let me stress that we are not writing this letter from a position of capital weakness. It is quite the reverse."

Andy Hornby: Is this in my pack?

Lord Turnbull: I do not know that it is in your pack, but we can certainly supply it to you.

Andy Hornby: That does not matter, it’s fine.

Q1487 Lord Turnbull: The real question is: had you really understood the seriousness, and the origins of the seriousness, to write that you were writing from a position not of weakness, but quite the reverse?

Andy Hornby: What date was that?

Lord Turnbull: That was 1 August 2008.

Andy Hornby: Obviously, I am not trying to condone that-

Lord Turnbull: It is a tease, so you don’t need to answer it.

Andy Hornby: That was soon after the rights issue had raised considerable extra equity capital, but I take your point.

Q1488 The Lord Bishop of Durham: The first line of defence, as it was called, for risk management was at divisional level, which would be the divisional risk committee. That is correct, isn’t it?

Andy Hornby: That is correct. Just to be clear, though, there were three lines of defence: the first was the divisional management and risk teams within the division; the second was the group risk function in group finance; and the third was internal audit and the audit committee and, in particular, the chairman of the audit committee.

Q1489 The Lord Bishop of Durham: What about the relationship manager-the person actually dealing with the client? In my experience they were always the first line of defence.

Andy Hornby: That is absolutely right. Clearly the credit processes and the relationship management points in corporate banking were very different from those in retail banking. Retail banking in general has moved to an automated credit decision process, except at the very high net worth end of the market. The relationship side is largely about managing process and helping the customer, as opposed to credit decision making. I think that you are making the point, on which I agree with you, that ultimately, with individual corporate loans the biggest line of defence has to be how they have been assessed by the people closest to the customer.

Q1490 The Lord Bishop of Durham: The FSA, at paragraphs 4.26 and 2.8-I may have missed others-of the final notice, commented that, at the individual relationship or sales end, there was a very strong emphasis on revenue and nothing about risk; risk was left for someone else to deal with. Do you not think that this was a change of culture that led to a failure of banking standards?

Andy Hornby: I have to say that of all the statements within the FSA report, that was the one that disappointed me and surprised me the most, because-I sound like an old record-although I fully accepted that the weighting towards commercial property and leveraged loans, in a world where wholesale funding was about to dry up, left us extraordinarily vulnerable, to be fair to the Bank of Scotland corporate processes, they were built on very, very long-term customer relationships. That had been very much the heritage of the corporate bank, so that bit surprised me of all the statements within that particular issue. You are right, however, that the fundamental question has to be how your relationship managers assure themselves that they are being objective, careful and prudent, but also as helpful to the client as possible.

Q1491 The Lord Bishop of Durham: I dealt with the Bank of Scotland and borrowed large sums of money from it back in the ’80s. I remember Gordon McQueen and Peter Brown. They were not very prone to taking risk; it was like screwing blood out of a stone to get them to part with their precious money. What changed? Was that to do with bringing in a sales culture after the merger?

Andy Hornby: No, I do not think so. HBOS was an amalgam of very different cultures. There was not a unified culture within HBOS at all, in that the retail bank had much more of a sales and process culture and automated decision making. The corporate bank had much more relationship banking, building off innovative structures and historical relationships. Insurance investment in itself had two separate and very distinct cultures: one, in terms of general insurance, was much closer to the retail banking model, with straightforward products; the other, in terms of life assurance, was unrecognisable to the other parts of HBOS and much more akin to what you would find in Aviva or the Prudential. I do not think it was a sudden change in culture. To go back to where I think Lord Turnbull was heading, there was no doubt that what did change, Lord Bishop, is that the balance sheet was capable of doing much larger deals. That was in terms of the structure of the size of transactions that the corporate bank did. That did change.

With a glorious degree of hindsight, the second thing that changed is that Bank of Scotland, because of the long-term reputation in these markets, had very good deal origination capability prior to August 2007. This is something I should have mentioned to you, Mr Quest, when you were questioning me earlier: if you look at the periods prior to August 2007, typically profits in corporate grew much faster than assets. Even when the assets had been slowed down to more like 9% per annum, you can see profits were still often around 20%. The reason for that is that Bank of Scotland’s distribution system allowed us to syndicate a lot of those loans very quickly. In effect, you originated the loan and sold it on. With the glorious benefit of hindsight, what happened from August 2007 onwards is that when wholesale markets started to freeze, syndication markets froze.

Q1492 The Lord Bishop of Durham: We saw that in the report. When the merger happened between Halifax and Bank of Scotland, would it be fair to suggest that the expectations that were put to the market were of significant growth and of a new major force in banking?

Andy Hornby: Yes, that is true; we were portrayed to the market. If you look at analysts’ reports from 2002 and 2003, they were typically expecting around 20% earnings growth through those first three years.

Q1493 The Lord Bishop of Durham: And yet, to quote the first sentence of the Financial Times leading article on the day after the failure of Continental Illinois in the ’80s: "Banks should be boring." Twenty per cent growth is anything but boring. Is that not a very significant change in banking standards? Much as I liked them, I found the Bank of Scotland were pretty boring; they were enjoyably boring.

Andy Hornby: I think that it is undoubtedly true that given the synergies that were being delivered, many of which were cost synergies through those first three years and were very high, the earnings growth was extremely high. To be fair, Lord Bishop, from memory-I have checked as well as I can from the annual report-the asset growth went from around 16% per annum from 2001 to 2004, which is extremely high for those three years, although many other competitors were growing at similar rates, to more like 9% afterwards. It is therefore a tangential question, but a good question: should we have grown even more slowly in the first three years, and should we have pulled back even further in those following three years? Clearly, with the wisdom of hindsight, the smaller the amount of assets, the better.

As to the new force in banking and what came with it, a lot of the earnings growth was driven by cost synergies, and by other activity, which did largely play through in those first three years. That is why the board took a conscious decision to pull back on growth from 2005.

Q1494 The Lord Bishop of Durham: And yet even during that period, am I not right in thinking that you ceased to have the treasurer on the board?

Andy Hornby: That is correct.

Q1495 The Lord Bishop of Durham: And the treasurer is-again, speaking from personal experience-the person who says, "Great idea, but we can’t do it. We have not got a stable funding platform." I am suggesting that this is another sign of a sales revenue-driven culture rather than a prudent and slightly boring culture, perhaps driven by market expectations.

Andy Hornby: I do not think I would use the words sales culture.

Q1496 The Lord Bishop of Durham: It is what the FSA-

Andy Hornby: I am not going to deny the growth figures that we have talked about-the fact that the bank’s assets did grow by around 16% per annum for the first three years, and at 9% to 10% were still growing pretty strongly from ’05 onwards.

Q1497 Mark Garnier: Mr Hornby, you described earlier the group risk structure. Can you go over it again, because you were quite quick, and it was quite complex?

Andy Hornby: Keeping it as simple as I can, as the Lord Bishop said, in effect the annual report would describe three lines of defence. First, within each division, and we had five divisions for most of the time, as well as the executive team-the chief executive of the division, the finance director, the head of operations, etc.-there would be a head of risk within the division. Typically, the head of risk would split activities under him or her into three areas: credit risk, regulatory risk and operational risk.

Q1498 Mark Garnier: Operational risk?

Andy Hornby: Operational risk is much more important in, say, retail banking, where we were managing over 1,000 outlets and you had to make sure that colleagues knew exactly what processes to follow operationally. In corporate banking, clearly the credit side was far and away the most important, but nevertheless there was a risk within each division-I do not want to over-complicate it. The divisional risk people would report direct to the CEO of the division.

Q1499 Mark Garnier: So the divisional risk managers reported to the CEO of the division.

Andy Hornby: However, the group risk team-the second line of defence-was there to oversee risk activity in entirety, and to look at the aggregated position across the group. The group risk team was typically split into two large chunks, similar to what I described, one looking at credit trends, and one looking at regulatory risk and regulatory trends. The group risk director, in the early days, reported to the finance director, and in the latter days reported direct to the CEO. For what it is worth, I believe they should report direct to the CEO.

Q1500 Mark Garnier: What role did the global risk director play?

Andy Hornby: The group risk director would be responsible for analysing and presenting back to the board the group’s overall risk position. Typically, the head of credit risk would come along to the board and present the overall credit trends, having studied that from the credit committee. Typically, you would have a head of regulatory risk as well, under the overall head of group risk.

The other thing to stress is that group risk was also represented on each corporate divisional risk control committee. It is not that group risk was operating up in the ether. An individual from group risk sat on each of the individual corporate committees.

Q1501 Mark Garnier: Who set up that structure?

Andy Hornby: It was set up at the time of the merger, in 2001.

Q1502 Mark Garnier: Who was responsible for setting it up?

Andy Hornby: It would have been set up by James Crosby, and the group risk director at the time and the finance director at the time.

Q1503 Mark Garnier: Is group risk director the same as global risk director? I have a note here that Jo Dawson was global risk director. Is that the same thing?

Andy Hornby: Yes. It’s the same thing.

Q1504 Mark Garnier: Does that not strike you as being a slightly baffling structure?

Andy Hornby: No. I think it is logical, because it aims to provide two sets of checks and balances. One is that the group risk team knows enough about what is going on in the divisions by sitting on risk control committees. Secondly, they have the ability to challenge the overall operations of the group by reporting direct to the CEO or, in the early days, the finance director, and being present on the executive committee.

Q1505 Mark Garnier: In his evidence to us, Paul Moore basically talked about that as dysfunctional. He said: "There was a constant discussion-which is a soft way of putting it; ‘argument’ might be a better way-as to exactly what level of reporting the divisional risk functions should have to the specialist group risk functions. It is commonly referred to as a functional reporting line: that means they report to you in terms of their technical expertise, but they do not report to you in terms of appraisal or performance" and on it goes. It strikes me as an utterly baffling reporting line, full of dozens of opportunities for it just not to work.

Andy Hornby: Two things. Firstly, there were only two changes made to the reporting line, and I think most banks have now moved to having risk reporting direct to the risk director all the way through, which is probably logical. I do not believe that it made a huge difference in our particular case, because the lines of control and the ability for group risk to understand what is going on in divisions is high. In internal audit, the teams always reported straight through to the finance director and, ultimately, to the head of internal audit.

I accept the fact that where you put the direct line below the divisional CEO level can make a difference. I think it is simpler to have the group risk director having a straight-line report all the way through, but I do not believe that it is a panacea. The panacea is whether the information is presented in a way that alerts people to the right risk and whether group risk gets enough of an insight as to what is really going on within divisions in a very, very large bank.

Q1506 Mark Garnier: The trouble is that it looks like you have-I am trying to fathom this out-15 people. You have five divisions-one for credit, one for regulatory and one for operational risk in each one of those, so that is 15 people. You then have their bosses, so that is now up to 20 people. They then go up to the group risk thing where you have two different divisions. You have an awful lot of links in this chain, every single one of which is potentially a weak link. When Jo Dawson was appointed by James Crosby, it is noted that she had no risk experience at all, so she did not understand risk. She was running a very complex department, which was basically there to ensure that you did not screw up. Dan Watkins-did you appoint him?

Andy Hornby: I believe that Dan Watkins was appointed in ’06, so, yes, I would definitely have been involved in his appointment as group risk director.

Q1507 Mark Garnier: What assessment did you make at the time of his experience in risk management?

Andy Hornby: I thought that Dan was the most experienced person we had in the group.

Q1508 Mark Garnier: In terms of risk or just experience?

Andy Hornby: In terms of risk as well. It is interesting, with the glorious benefit of hindsight, that back in ’05-06 some of the biggest risks that the markets believed that HBOS faced were in the residential mortgage side, where we have obviously been monitoring house-price trends for a long time. Dan had spent his entire career in the old building society world and then the Halifax, and had been managing director of Birmingham Midshires, which is the higher risk element of our mortgage business, because it did specialised mortgage loans.

Q1509 Mark Garnier: But that does not mean that he is skilled in risk.

Andy Hornby: No, but prior to that he had worked for Morgan Grenfell in treasury, so I thought that his track record, in terms of having been in treasury prior to moving into retail banking and then having launched-

Q1510 Mark Garnier: It keeps coming up; you keep talking about the first line of defence being the divisional risk department, but the first line of defence is not actually the risk team-it is the business team. That is what is widely accepted as being the first line of defence. The risk people, being the middle office of that function, are the second line of defence. Surely, by saying that the divisional risk team is a first line of defence, you have actually completely poorly constructed your first line of defence in your bank.

Andy Hornby: No. I understand what you are saying, but I think it is semantics. If I did not pronounce it properly, I apologise. The division should be the first line of defence.

Mark Garnier: The business division?

Andy Hornby: The business division. With the risk function properly integrated into managing all of those processes.

Q1511 Mark Garnier: It was clearly described to us in another evidence session in terms of a game of cricket. The first line of defence in a cricket match is not the wicketkeeper; it is actually the bowler. That is the one who is starting the business in the first place. You are describing the risk team, who are not in the business of winning business-going out and getting business-as being your first line of defence, yet most people would identify the first line of defence as the business winners, the people driving the business.

Andy Hornby: I agree with you entirely. The ultimate buck has to stop with the business winners and they have to make the right decisions. All I am saying is that I think that process of the divisional risk team being properly integrated into credit processes into challenge is important. Of all the things I would not change if I was involved in trying to make sure that banks do not fail in the future, it is really important that you have strong divisional risk executives within the division because these banks are so broad. The range of complexity within the different divisions is so broad. I think it is a good idea to have straight-line reporting up to group risk, as opposed to the divisional CEO, but I would counsel strongly against removing them from what I call the daily operations. If you don’t, you will just be getting too much of a pure helicopter view.

Q1512 Mark Garnier: Can I ask one final very broad question? You were doing incredibly well. Did anybody ever sit down at board level or any other level and just say, "Why are we so successful? Why are we being so good? Is it just that we are brilliant at what we do and so we should pat ourselves on the back?" Where was that challenge?

Andy Hornby: I think that from around 2006 onwards, we did not perceive that we were outperforming. Certainly I didn’t-being absolutely blunt.

Mark Garnier: There was an 11.9% compound annual growth rate in your assets.

Andy Hornby: I did not perceive it in terms of-again, from memory, I am struggling to remember from ’06-07-the financial performance of some of the monoline mortgage banks. Northern Rock, for example, was far stronger in terms of profit growth. The profit growth of the likes of Barclays was far stronger, because they had a very strongly growing investment banking division, as did RBS. When you just sat back and looked at our relative performance versus the peer group, in the same way as Mr Quest just did with impairment performance, I did not perceive from the time that I took over as group CEO in summer 2006 that we were outperforming or that our pace of growth was stronger than others.

In the early years, I think that we always-If you look at the detail of the business plans-again I am going back an awful long to time in my memory to ’01,’02,’03-about half of the profit growth was put down to synergies, particularly cost synergies and some revenue synergies. So although we were growing pre-tax profits by around 20% per annum, we were constantly telling the markets, and the markets were actually saying, "You’re going to revert to the norm from about 2005 onwards". That is broadly what happened. I think the big question is did we ask ourselves whether the wholesale funding markets could ultimately-

Chair: You have raised that on a number of occasions already.

Q1513 Baroness Kramer: If I could go back to this first and second line of defence, because obviously one of the things we are trying to do is understand what happens so that we don’t see repeats of it. You describe the relationship but we have had quotes from Paul Moore talking about the relationship between group risk and divisional risk as dysfunctional; but then Jo Dawson, who obviously had no axe to grind in a sense because she went on to a successful career in the bank, made essentially the same comment. It depended very much on the personal relationships between whoever was running the group bit with the divisional bit. Surely that is dangerous from an institutional perspective. Is it that you had a divisional section that was so confident in its ability to assess credit, particularly since it had its own credit gurus, that the ability of an independent second line to come in and seriously challenge it was totally compromised? Where you have very big beasts who are strong individuals running a division, unless the chief executive and the board provide that status for the second line, that challenge does not take place. Is that the situation we are looking at?

Andy Hornby: You ask the fundamental question. I think that there are only two responses to it. In big, diverse banks, to have a technically strong and personally adept group risk director is totally crucial because to be able to see through the various trends to what the really big things are that need to be challenged is utterly crucial. Secondly, I believe that it is easier if the divisional risk teams have a straight-line reporting relationship to the group risk director, as that takes away an element of potential tension. Ultimately, though, however good your credit risk assessors, divisional risk teams and group risk teams may be, you need to ensure that there is a proper culture of welcoming challenge from the risk teams. That is responsibility of the entire board, and that has to be constantly emphasised.

Q1514 Baroness Kramer: Can I ask you about the role of the non-execs who chair many of these committee meetings? To what extent were they trying to keep the peace between two sides that had some fundamental disagreements, in a sense to suppress the challenge rather than to understand and facilitate it, particularly since none of them had especially good experience within the areas they were chairing?

Andy Hornby: That is a very good question, Baroness Kramer. Let me try to answer it from the most personal point of view. As chief executive of the retail bank from ’01 to ’06, I sat on that risk committee and, for most of that time, Charles Dunstone was the chairman. He was clearly not a career banker, but I felt that, partly because he was not a career banker, he worked hard to ensure that the voices of group risk and group internal audit were properly voiced in those meetings. There was even a formal process whereby, having gone through all the individual items on the agenda-these meetings tended to take around four hours, so they were long meetings-both the attendee from group risk and the attendee from internal audit-

Q1515 Baroness Kramer: So it would not always be the head of that division; they might send somebody more junior to the committee?

Andy Hornby: That’s correct. For the head of group risk to go to every single divisional credit meeting and every single divisional risk control meeting would have been very difficult.

Q1516 Baroness Kramer: But divisional would have sent a senior person?

Andy Hornby: Always a senior person, and group risk and internal audit had a senior appointee who always reported to the head of group risk or the head of internal audit on each of the divisional risk control committees. Sometimes, the head of group risk would attend as well, but he would have a regular appointee.

The point I was trying to make is that my memory is actually of the chairman doing a good job of always making sure that, at the end of every meeting, group risk and internal audit had the chance to raise anything that they wanted to. It was under "any other business"; nevertheless, it was on the agenda.

Q1517 Baroness Kramer: Lastly, were any of these dysfunctional tensions reported up to you or, as far as you know, any other member of the board? People seem to be quite happy to speak freely about them to the panel.

Andy Hornby: No. I was chief executive of the retail division at the time you are talking about-

Q1518 Baroness Kramer: Where, frankly, there doesn’t seem to have been that same tension.

Andy Hornby: I was aware of the very healthy challenge that group risk had about some issues within retail, and particularly around some of the issues that we ended up spending a year working through with the FSA, but I regarded that as a proper challenge. As divisional CEO, I did not regard it as a problem to be challenged about this. That is what should happen.

Q1519 Baroness Kramer: But I was asking, when you were CEO of HBOS, were those worries from group risk that they have been glad to share with us communicated to you?

Andy Hornby: Yes. I have to say that it was a relatively short period of time, from August 2006 to August 2007, when the credit crunch really did kick in. I had a year, basically, of more normal process as CEO, and then I had 15 months when in all we were doing, 17 hours a day-that is no exaggeration-was spent with the group risk director and the finance director, Peter Hickman and Mike Ellis. That was the entire process. The whole business had been turned on its head, and every Friday the group finance director chaired a meeting on how much assets were being written and how quickly it was being syndicated. At that stage, everything had changed, and it was entirely central control. It is an atypical period, if I am honest.

Q1520 Chair: Speaking of his time immediately preceding you as chief executive, Sir James Crosby admitted that HBOS had become vulnerable not merely because of what you described as double gearing, but because corporate lending, in particular, was the result of incompetence. A lot of your inheritance was just bad lending, wasn’t it?

Andy Hornby: How you divide up those impairment charges between the double gearing impact that we have talked about, whereby wholesale market seizing led to extraordinary decline in asset values, and the percentage of bad lending decisions-I wish I could do it perfectly for you, but I clearly cannot.

Q1521 Chair: But you are well placed, since that was your inheritance, to have a stab at it. Give us a proportion.

Andy Hornby: I believe most of it was the double gearing impact. The reason I say that is when you look at comparable banks with large commercial property books that were wholesale funded, they have ended up in similarly appalling and parlous states. I am not using that as an excuse, however.

Q1522 Chair: Those are not similar statistics, though, are they? Impairments are much worse in HBOS than in other banks.

Andy Hornby: I was looking more at some of the Irish banks and some of the other people with a very high concentration in some of these areas.

Q1523 Chair: Let us just have a look at some of the lending you did or you were particularly responsible for. I was surprised by a couple of things you said with respect to the growth on the international side. You said with respect to Australia that you were confident that growing the corporate loan book was the right thing to do.

Andy Hornby: No, sorry, I did not say that. I apologise if that was not clear. What I said was that the impairment numbers in this schedule have taken out the sale of Bankwest at the end of 2008. Our Australian business was in two parts. Bankwest was just a traditional mortgage bank, based in Perth. It was largely a retail business with an SME franchise, and then a corporate bank that was built on the back, largely run out of Sydney. I totally agreed that the impairments from the corporate lending in Australia were very poor. I was merely saying that these figures as a percentage of assets have taken out the fact that the retail bank had just been sold, and therefore you are only looking at a pure corporate book. I am not taking away from your conclusion at all that the impairments that grew up in the corporate book are not acceptable. I agree with you.

Q1524 Chair: They are truly horrendous, aren’t they?

Andy Hornby: They are far too high.

Q1525 Chair: They are staggering-28%. You also said about Australia, and this surprised me, that this was an area you had been looking at particularly carefully. So this staggering level of impairment grew in the very area that you were monitoring with great care.

Andy Hornby: In terms of the process put in place for monitoring the growth in Australia, and indeed in Ireland and Europe, we did three things. First, we very deliberately had in charge one of our most experienced corporate bankers. Colin Matthew, who had been on the board since 2001, had run treasury for the Bank of Scotland for many years and had been a corporate banker in the Bank of Scotland throughout his entire 30 or 35-year career.

Secondly, we appointed a CEO in Australia-to be fair, the appointment was made before I took over as CEO-called David Willis, who was a lifelong banker. He was from New Zealand but he spent his entire banking career in that part of the world, because we knew that it had very specific risks. What I do say in my submission, Mr Tyrie, is that I wish we had been able to have a much higher percentage of our growth on the retail banking side in international generally. That was the goal. The goal, obviously at a far lower risk, was to grow retail deposits and mortgages. We did grow Bankwest well, but clearly that was sold at the end of 2008 as part of the agreed merger with Lloyds. I believe that business has carried on performing well, but the corporate loan book performance in isolation, when you take out the two thirds of the asset with Bankwest, was unacceptable.

Q1526 Chair: If you look at the picture overall, we have a bank with very experienced bankers. You were describing how you got people in place with 30 years’ experience in the key areas, particularly those where you did not have so much personal experience, and very high levels of challenge from the non-execs. That is what you have told us. There was digging down into a great deal of detail, going through with a fine-toothed comb all the detail in every area, yet the bank catastrophically failed. This whole superstructure of detailed work turned out to be completely valueless, didn’t it?

Andy Hornby: It did, because the failure-which I believe was largely down to the seizure of wholesale markets and its gearing impact on corporate lending-was not defined or predicted by our superstructure. I have asked myself through many sleepless nights over the past five years what the superstructure that could have helped us predict that could have been. I am not sure it is an issue of pure corporate governance. I think it is an issue of, how do you constantly think the unthinkable in terms of truly predicting what the ultimate risk events could be? I accept the fact that the supertanker-your word-structures, the divisional structures and so on, did not define that risk.

Chair: It has been a long session this afternoon. Thank you for coming in. We will resume in public session tomorrow at 9.30 am.

Prepared 27th December 2012