By Daniel Hunter

The Financial Services Authority (FSA) has confirmed publicly that it has been carrying out an enforcement investigation into HBOS in respect of specific issues relevant to its failure during the wider financial crisis.

The investigation into the firm has now concluded and the FSA has published a Final Notice detailing its findings in respect of failings of Bank of Scotland PLC (‘Bank of Scotland’), a subsidiary of the HBOS Group, in relation to its Corporate Division (‘the division’) during the period January 2006 to December 2008.

The FSA judged that the firm was guilty of very serious misconduct, which contributed to the circumstances that led to the UK government having to inject taxpayer funding into HBOS.

The FSA considers that during this period, Bank of Scotland failed to comply with Principle 3 of the FSA’s Principles for Businesses. Principle 3 states: “A firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems”.

The severity of Bank of Scotland’s failings during this time would, under normal circumstances, be likely to warrant a very substantial financial penalty. However, because public funds have already been called on to address the consequences of Bank of Scotland’s misconduct, levying a penalty on the enlarged Group means the taxpayer would effectively pay twice for the same actions committed by the firm. Therefore, to reflect these exceptional circumstances, the FSA has not levied a fine against Bank of Scotland but has issued a public censure to ensure details of the firm’s misconduct can be viewed by all and act as a lesson in risk management failings.

Summary findings:

Between January 2006 and March 2008, Bank of Scotland’s Corporate Division pursued an aggressive growth strategy that focused on high-risk, sub-investment grade lending. Over the period, the division’s transactions increased in size, complexity and risk. Its portfolio was high risk with highly concentrated exposures to property and to significant large borrowers.

This strategy was highly vulnerable to a downturn in the economic cycle, yet the Corporate Division continued with the strategy even as markets began to worsen in 2007. Rather than re-evaluating its business as conditions worsened, the division set out to increase its market share as other lenders started to pull out of the market. In addition, its internal culture was focused on revenue rather than assessing the level of risk in transactions.

Bank of Scotland did not have systems and controls that were appropriate to the high level of risks that its Corporate Division was taking on, and there were serious deficiencies in:

Bank of Scotland’s control framework which provided insufficient challenge to the Corporate Division’s strategy;
the framework for managing credit risk across the portfolio;
the distribution framework which did not operate effectively in reducing the risks in the portfolio; and
the process for identifying and managing transactions that showed signs of stress.

From April 2008, as it became apparent that high value transactions were demonstrating signs of stress, it should have been apparent to Bank of Scotland that a more prudent approach was needed to mitigate risk, yet it was slow to move such transactions to its High Risk area within its Corporate Division. There was a significant risk that this would have an impact on the firm’s capital requirements. It also meant the full extent of the stress within the corporate portfolio was not visible to the Group’s Board or auditors. In addition, while the firm’s auditors agreed that the overall level of the firm’s provisioning was acceptable, in relation to the Corporate Division provisions were consistently made at the optimistic rather than prudent end of the acceptable range, despite warnings from the divisional risk function and Bank of Scotland’s auditors.

Tracey McDermott, FSA acting director of enforcement, said:

“Banks and other firms have to manage their business by ensuring that their systems and controls are appropriate for the risks that they are running.

“The conduct of the Bank of Scotland illustrates how a failure to meet regulatory requirements can end not just in massive costs to a firm, but losses to shareholders, taxpayers and the economy.”

This announcement marks the conclusion of the enforcement action against the firm, but other enforcement proceedings in connection to the failure of HBOS are ongoing and remain subject to the legal processes prescribed by the Financial Services and Markets Act 2000 (FSMA).

The FSA has publicly committed to produce a public interest report into the causes of the failure of HBOS. To carry out work on an HBOS report at this time would risk legally prejudicing the outcome of ongoing enforcement action. Therefore, it is our intention that the review and analysis work to produce such a report will commence at the conclusion of the enforcement proceedings connected to this matter. The start date for this will be determined by the progress of the enforcement action.

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