by Perman, Ray
Walker’s report also called for more board involvement in ‘risk oversight’ with particular attention to the monitoring of risk and discussion leading to decisions on the bank’s risk appetite and tolerance, but how this was to be achieved by non-executives having to grapple with the scale of complexity of modern banking it again did not specify. It did make a plea for a greater involvement by institutional shareholders. On remuneration, it looked only at executive pay and did not comment on the objectivity of non-executives.
HBOS clearly exhibited a breakdown in corporate governance, which despite many thousands of words of lip service paid to it, failed to control the group. But do not expect change – at least not in the near future.
22
The drive for profit at any price
It is not often that the veil which shields the inner workings of a massive corporation is lifted to let us see the machinations hidden behind it, but the 2012 FSA report into HBOS corporate banking1 gave some astonishing insights. Here was a division that had delivered phenomenal growth, being constantly pressed to go further – whatever the consequences.
The regulator looked specifically at the corporate department, yet it also threw a strong light on the group management of HBOS, which had a seemingly insatiable demand for more profit regardless of the economic or competitive situation. It was an executive which did not address the inadequacies in its monitoring, control and management of risk and deluded itself on the chances it was taking. Its internal business plans spoke of ‘measured lending growth’, ‘sound credit quality’ and ‘a conservative approach to credit risk management’, when all the time it was pushing more and more lending, reducing the quality of the deals it was doing and running higher and higher risks.
The FSA looked in detail at the period from 2006, when the economic boom was reaching its peak, to 2008 when HBOS had to be rescued by Lloyds. During this time HBOS made repeated statements in its internal plans that the business was adopting a selective and cautious approach to lending, sentiments it repeated in its annual reports to shareholders. The truth, however, was very different. Succeeding plans set ever-increasing and highly challenging targets for profit growth from the corporate banking division, which was being forced to make up the shortfall in the profits from the retail division. This could only be achieved by rapid increases in the amount of lending it was doing, with consequent effects on the quality of the commitments it was taking on and the risks it was running.
At the end of 2005 HBOS realised that the market was becoming more difficult. The boom was topping out, strong competition for leveraged debt deals were cutting margins and increasing risks and internally the corporate banking division still had management issues it had not resolved. In its business plan, corporate proposed increasing its lending by 6 per cent during 2006 and generating 9 per cent more in profit. This was not considered good enough: HBOS ordered the division to double its profit target. In fact it nearly achieved that higher level, turning in 17 per cent more profit on lending up 8 per cent. But there was a cost; much of the lending was in property and higher-risk transactions.
By the start of 2007 it was clear the economy was deteriorating and that risks were increasing, particularly in leveraged finance. Corporate banking budgeted for a profit growth of 10–12 per cent for the year, but was again directed by the HBOS group management to up the target. A new plan was written showing profit growth of 22 per cent on lending up 9 per cent. Even this was not good enough. The FSA found that the HBOS group management increasingly looked to the corporate division to make up for the underperformance of residential mortgages and personal lending. In April 2007 the profit growth target was increased to 30 per cent. In June 2007 the targets for the year were increased again to 35 per cent. By the end of July 2007, corporate banking had generated 85 per cent of the profits it made in the whole of 2006 and was 21 per cent ahead of plan. Lending grew by 5 per cent in this period.
This astonishing performance was achieved by doing bigger, riskier deals and committing more money to property. Credit standards were already low, but the quality fell below even the levels set in the division’s plan.
By the autumn of 2007 the credit crunch was beginning to bite. In the US two hedge funds had collapsed, French bank BNP Paribas had difficulties and Northern Rock was teetering on the edge of bankruptcy. The property market was looking bad and the syndication market for loans, an important part of HBOS’s strategy to spread risk, had practically dried up. Despite all this, corporate kept lending. ‘This strategy involved supporting existing customers (which in turn further increased the business’s exposure to significant large borrowers) and actively seeking to increase market share. Significant volumes of new business continued to be sanctioned by the corporate division in this period,’ the FSA said.
The corporate division’s business model depended on being able to unload risk by selling part of any transaction to other banks. It would typically take 100 per cent of the exposure of any deal it made onto its own loan book and subsequently try to sell part of this to other banks until it reached a targeted ‘hold position’. Its preference to find and structure deals itself meant that it earned more fees, but it also ran more risk than if it did them on a club basis with other banks, with the risk and the fees shared from the start. As 2007 went on it was becoming increasingly difficult to sell down, but still the deal-making went on. A number of large deals were done against the advice of the corporate banking division’s loans distribution unit and without any proper assessment of the increased risks from not being able to sell down. Deals awaiting syndication piled up so that by 30 April 2008 the value of the corporate division’s loans waiting to be sold down was £9.7 billion.
Despite the difficult economic environment in the last five months of 2007, corporate had achieved impressive growth for the year. Profits were up 32 per cent – 7.5 per cent above the original plan target and just £60 million short of an ambitious target of £2.4 billion set at the end of June. Lending grew by 22 per cent; but again there was a price. Property lending had been increased by 15 per cent, just as the market was turning down, the equity portfolio was being built up and there were large increases in higher-risk structured and leveraged deals. The division continued to lend and buy equity stakes in ventures into 2008, doing bigger and riskier deals. In the first three months of the year it did 46 deals of £75 million or more, with a total value of £11.6 billion. At the top end, 11 transactions were worth £250 million or more each, adding up to a total value of £7.1 billion. Again, credit quality was lower than planned.
The report showed a division running fast just to stand still. The high turnover rate on the corporate loan book meant that approximately 30 per cent more deals had to be done each year just to ensure that the size of the book did not reduce. But corporate banking was still being urged to do more. It was given challenging growth targets – which were often met and exceeded.
There was only one way to satisfy these demands: take bigger risks. The corporate division was the riskiest part of HBOS and it took more risks than other major UK banking groups. The corporate banking loan book was already high-risk and low quality, considered sub-investment grade by the ratings agencies. But in achieving its lending and profit targets, the corporate division went lower than even its own plan demanded. A substantial proportion of the profit growth was coming from higher-risk areas of the business, in particular Joint Ventures and ISAF (Integrated, Structured and Acquisition Finance, the bank’s debt-to-equity one-stop shop) which originated the majority of corporate’s risk capital deals. Overall the average credit quality of new and renewal business remained low, but deals originated by these two departments turned out to be even lower in quality.
A high proportion of lending was in property, which meant that the bank was heavily exposed to a downturn. At the start of 2006, 52 per cent (or £44.4 billion) of the money corporate had lent was to the commercial property market. By the end of 2008, this proportion had risen to 56 per cent (
or £68.1 billion). Another factor was that it was unduly exposed to large ‘single name’ borrowers. At the start of 2006, its top 30 borrowers accounted for 15 per cent of the value of the corporate portfolio (£19.2 billion). By the end of March 2008, this had increased to 23 per cent (£34.1 billion). To compound the problem in many transactions, corporate’s exposure to a large single-name borrower also involved commercial property and/or risk capital and/or were highly leveraged, further deepening the level of concentration and risk. The size of these exposures meant that any default would have a high impact on the loan book.
Peter Cummings’ policy of buying shareholdings in companies and of providing equity finance alongside debt also came in for scrutiny and the old danger of a conflict of interest between the lender which wants to get its money back and the shareholder trying to protect its investment began to surface.
The corporate division operated a ‘one-stop-shop’ model for integrated finance, which meant that the risk in individual transactions received less scrutiny than if debt and equity had been required to be approved and managed separately. This was the highest-risk area of the corporate book. Compared to lending ‘senior debt’ where the borrowing was secured against the assets of the company, buying shares was much more risky. There was no collateral to back the risk capital (shares) and shareholders had less control over the assets of a company compared to lenders, who could insist on covenants. These risks were compounded by conflicts of interest, which would become particularly acute if the transaction became ‘stressed’ as the interests of senior debt holders would differ from those of risk capital holders. Despite this, the division’s exposure to risk capital grew rapidly. At the start of 2006, the reported value of corporate’s debt securities and equity shares was £2.3 billion. By the end of August 2008, this had increased by 139 per cent to £5.5 billion. To meet the challenging targets it had been set by the group executive, corporate generated significant profits by selling investments. But these were one-off gains and in order to keep the profit stream going, new deals had to be found.
If the risks were going up, so were the stakes. Deals which involved lending over £75 million, or making a substantial equity investment, had to be sanctioned by the Executive Credit Committee. There was a significant increase in the volume and complexity of deals that this committee approved during 2006 and 2007. In 2006 199 deals of more than £75 million were approved, which represented total lending of £56 billion. The following year this went up to 361 approvals, with a total value of £96.2 billion. At the higher end of the lending scale there were 56 approvals of lending over £250 million in 2006 (total lending: £36.2 billion), which nearly doubled to 110 approvals in 2007 (total lending: £64 billion). The size of these transactions meant that any default would have a high impact on the book.
To achieve the levels of profit it wanted, HBOS concentrated on low-grade/high-risk opportunities which would command higher interest rates and fees. Yet it never made this explicit to its shareholders. In the annual report for 2007, for example, the comments of chief executive Andy Hornby were all about return and played down the higher risk that inevitably went with bigger returns. Low-grade investments were euphemistically called ‘alternative asset classes’ and a concentration on a few high-risk areas was described as ‘value-enhancing specialisation’. There was a comforting allusion to reducing risk by sell-down, even though by the time the report was written the syndication market was effectively shut.
Hornby wrote:
In our corporate business we continue to concentrate on markets where we have real expertise and can generate superior returns. Through a focus on the individual risk:reward characteristics of alternative asset classes, we aim to bring a clear value-enhancing specialisation to our customer relationships. Assets are originated on the basis that they will be held on the balance sheet in their entirety, even if subsequently a proportion of debt or equity positions are sold down to other market participants. This discipline ensures there is no disconnect between a decision to lend and the potential availability of higher returns through sell-down activity when market conditions are supportive.
In the corporate banking section of the 2007 annual report, Peter Cummings commented: ‘Controlled credit risk: Selective specialisation and strong client partnerships are all designed to manage the balance between risk and return.’ In fact the corporate division had a specific focus on sub-investment grade lending. It had a target portfolio rating of 5.2 (BB), which was considered sub-investment grade by the ratings agencies, but it failed to meet even that and consistently did deals which had a lower credit rating than the target. A proportion of the portfolio in particular risk capital transactions was not rated at all, which made it the highest-risk part of the book.
Throughout this period there was strong competition for deals among banks, and to hold on to customers the corporate division often had to increase its exposure on transactions that were already lowly rated. It did this by resorting to aggressive deal structures – for example high leverage multiples, low interest margins, weak covenants and/or riskier subordinated debt tranches such as PIK notes (‘Payment in Kind’, where the bank does not receive any interest until the loan is paid off). These aggressive structures increased risk as they made it more difficult for the corporate division to ‘sell down’ its exposure to other banks, which were much less willing to take them on.
The low credit quality of deals meant that there was a relatively high risk of default. Effective monitoring of individual transactions and the portfolio as a whole was therefore important. For example, the monitoring of deals to see whether a borrower was likely to break a lending covenant was vital because a breach was a trigger to consider whether to put a deal on the watch list or make a provision against possible default. HBOS relied on its relationship managers to do this, but the FSA found that there were continuing and significant weaknesses in credit skills and processes at all stages, from the origination of the loan to the final repayment. There were also repeated failings across all areas of the business of key controls, which were crucial to the effective sanctioning and monitoring of individual transactions.
The reason all this was allowed to happen was that HBOS’ corporate division operated in a culture that valued and encouraged sales above all else. Risk management was regarded as a constraint on the business rather than an integral part of it. Managers were incentivised to focus on revenue rather than risk, which increased their willingness to meet customers’ demands, increase lending and take on greater risk. Managers concentrated on one deal at a time, with insufficient regard to the portfolio as a whole and the business was resistant to change.
Achieving sell-down to the target hold position was a vital element of the corporate business model as a means of reducing its exposure to large leveraged transactions. But there were significant problems. The division’s loans distribution capability was limited in comparison to other banks and there were issues with the effectiveness and authority of the loans distribution unit. Deal teams resisted selling down parts of their deals because part of the fees earned had to be passed on to the buying banks and this directly affected their results and incentives. They priced transactions primarily in order to secure the business rather than in order to facilitate sell-down. The aggressive deal structures used by HBOS also made selling down loans harder, but deal teams continued to structure deals aggressively in order to secure the business.
In a number of large transactions, the corporate loans distribution unit expressed concerns about their ability to sell down particular transactions given the proposed pricing and/or structuring of the transaction. Those concerns were overridden and the transactions were sanctioned. In a number of these transactions, the target level of sell-down was not achieved and HBOS remained exposed to the whole risk.
Throughout the corporate division there was a ‘culture of optimism’ which made managers reluctant to admit how bad things really were. This meant that, even when potential or actual defaul
t had been identified, managers were slower than they should have been in referring the transaction to the specialist High Risk team, which meant that the risk of defaults was under-estimated. The FSA commented: ‘There was a significant risk that this would have an impact on HBOS’s capital requirements. It also meant that the full extent of stress in the corporate portfolio was not visible to the group executive, auditors and regulators.’ It added: ‘This optimism was unwarranted, without foundation and at the expense of prudence.’
HBOS adopted an optimistic approach to levels of provisioning against problem loans despite repeated warnings from its auditors and the corporate division’s risk specialists. The optimism bias was not challenged by the Group Risk department. The FSA listed the deteriorating situation as illustrated by HBOS’ repeated restatements of the level of ‘impaired assets’ within the corporate division’s portfolio and the level of provisions which had been made:
On 19 June 2008, HBOS issued a prospectus in relation to its rights issue. Corporate’s year-to-date impairment losses were not quantified or commented on in the prospectus, but management information indicated that, as at 31 May 2008, it had year-to-date impairment losses of £369.9 million. However at the end of July, HBOS published its interim results which stated that, as at 30 June 2008, there were year-to-date impairment losses of £469 million – a rise of £100 million in a month.
On 18 November 2008 in its prospectus for the placing of shares to the Government, HBOS said that, as at 30 September 2008, there were year-to-date impairment losses of £1.7 billion – a rise of £1.2 billion in three months. One month later – HBOS published a trading update which stated that, as at 30 November 2008, there were year-to-date impairment losses of £3.3 billion – a rise of over £2 billion in two months.
Throughout this period, HBOS’ auditors KPMG agreed that the overall level of the firm’s provisioning was acceptable. However, in relation to corporate, they consistently suggested that a more prudent approach would be to increase the level of provision by a significant amount. The firm consistently chose to provision at what KPMG identified as being the optimistic end of the acceptable range for corporate. KPMG’s view of what constituted the acceptable range was informed by management’s assessment of the degree of credit risk in particular transactions,