Did Crosby do anything to ensure that HBOS’s wheels didn’t come off?

February 12th, 2009

James Crosby: cavalier approach to risk


Sir James Crosby – a man last seen driving an eco-unfriendly “Chelsea tractor” with blacked out windows out of the gates of his home in Beckwithshaw, on the outskirts of Harrogate, North Yorks – has taken a hammering of late.

The attempts by Lloyds Banking Group  and government spin-doctors to rubbish Paul Moore, the whistleblower who revealed Crosby’s flawed approach to risk while he led HBOS (Sept 2001-July 2006), are clearly a wasted effort. The mud has stuck and to my mind it’s ingrained.

In this interview, given by Crosby to David Rough (the former head of investment management at Legal & General and a revered “bearish” fund manager), Crosby actually gave quite a lot away.

Recorded on January 20th, 2003, the interview was prominently displayed on pages three to eleven of HBOS’s 2002 annual report and accounts. Tellingly, it was headlined “How do you make sure the wheels don’t come off?”.

Reading between the lines of Rough’s questions, it is clear  that even then he believed that HBOS’s strategy was flawed. He clearly sensed, even at that early stage, that several wheelnuts were missing and that Crosby was extremely foolish to keep “flooring” the accelerator in a madcap quest for growth.

In the interview, the ex-FSA deputy chairman makes some extraordinary claims. Among these are his defense of HBOS’s desire to push ever harder in the UK housing market. Explaining the rationale for this strategy, Crosby said: “We’re just not heading for a significant set back in house prices.”

Is this the root of HBOS problems? How could anyone, and especially an actuary, have actually thought like that? All asset price bubbles in history have ended with a bust, so why on earth did Crosby think that the house price boom that had continued – albeit with the odd pause for breath – since 1996 would be any different?

It is also quite telling that the chain-smoking Eric Daniels, boss of Lloyds TSB, yesterday admitted that he wishes Lloyds TSB had had time to do proper due diligence on HBOS before it chose to acquire this poisoned chalice.

Daniels, who hails from Montana, yesterday told the 14 MPs on the Treasury Select Committee that the English bank had done 5,000 man hours of due diligence on HBOS. However he admitted that under normal circumstance it would have done between 15,000 man hours and 25,000 man hours before taking the plunge and buying a bank like HBOS.

Once the Conradian horror that lurks within HBOS becomes apparent, I suspect Daniels will wish he’d never bought HBOS at all.  I’d gladly accept a wager from Shane O’Riordain that buying HBOS is going to end up doing to Lloyds exactly what ABN Amro did to both the Royal Bank of Scotland and Fortis. Come on Shane, how about we bet £1000 on it!


To read this interview in a pdf version of accounts click here and scroll down to page three.

How do you make sure the wheels don’t come off?

DAVID ROUGH: You’ve been growing this business strongly, how do you make sure the wheels don’t fall off?

JAMES CROSBY: With the territory of growth comes a responsibility to ensure it converts into solid earnings. Our strategy demands tight control of costs, stable margins even though we’re delivering more to our customers and sound credit quality. Even in tough times we’re proving this is the strategy that delivers.

DAVID ROUGH: But what about credit quality, you’re not immune from these tough times?

JAMES CROSBY: No we’re not. One of our fastest growing areas is mortgages, they’re the highest quality assets in banking. Our strategy in other banking products is to offer value and simplicity to customers of our competitors. That really helps business quality, generally it’s the better quality customers who move for a current account that pays interest and it’s the better quality customers who come to you to transfer the balances on their credit cards.

DAVID ROUGH: The same cannot surely be said of Corporate credit?

JAMES CROSBY: No and as we’d expect in any slowdown our Corporate provisions have risen. Equally, that makes this an opportune time to lend, margins are wider, competition less intense and business propositions are more realistic.

DAVID ROUGH: In terms of your efficient, cheap and cheerful approach to your investment products – in falling equity markets haven’t your profits just been blown apart by the halving of equity markets?

JAMES CROSBY: Yes, our investment businesses have been hit by stock markets because the stock market level does drive revenues – it shows through this year again in a significant reduction in profits from our investment businesses because of “fluctuations due to short term investment returns” – of course recovering markets, whenever they happen, will have the opposite effect.

DAVID ROUGH: And will you, like many life companies, be fined for mis-selling of endowments?

JAMES CROSBY: I don’t expect so but when you make any comment like that, you always touch wood.

DAVID ROUGH: You appear relaxed about the prospects for the housing market. How are you going to survive or protect yourself in an at best, stagnant market over the next two or three years?

JAMES CROSBY: Whatever deterioration we see in retail credit in the UK, it’s likely to be comparatively benign, first because interest rates are so low and likely to stay so and second because we will see only a small increase in unemployment. This underpins retail credit generally but also the housing market.

DAVID ROUGH: Yes, but aren’t people just overstretching themselves?

JAMES CROSBY: Mortgage finance is much more affordable today than it has been for years – people are spending 15% of their income on mortgage finance against a long term average of 22%. There’s also a real shortage of housing – particularly in the South East! We’re just not heading for a significant set back in house prices.

DAVID ROUGH: But what about lending volumes?

JAMES CROSBY: We may have seen a boom in prices but transaction volumes over the last five years have been materially lower than they were in the late 80’s; in fact not much above the trend for the last thirty years. The housing market may well be slower in terms of price, but still good in terms of transaction volumes with good credit experience. Quite probably there is as much if not the same opportunity to grow the balance sheet as there has been over the last two or three years.

DAVID ROUGH: But what about the buy to let market – the rents for many parts of the South-East are actually falling rather than rising! Do you not see that house prices are going to be under pressure as the buy to let owners start having to be net sellers?

JAMES CROSBY: We’ve already seen what’s happened. It’s well over a year now since we saw a very significant fall in rentals in London. Why hasn’t that fed through to prices? It’s unusual. In the UK we are so hooked on owner occupation and the rental sector is so small that in practice we don’t switch from owning to renting because of price. You would have to see rentals fall an awful long way before they really influenced people’s preferences. The fact is, rentals have fallen and people have sold vacant properties for a good profit.

DAVID ROUGH: And are you part of the fraternity that are lending based on four times salary?

JAMES CROSBY: Not as a general rule. Almost all lending in the UK by mortgage lenders, not just us, is on the same income multiples as were applied in the late 80’s. The big difference is that on any scenario interest rates are less than half what they were then.

DAVID ROUGH: But the housing market is still surviving because interest rates are incredibly low. God forbid that interest rates ever go up; how do lenders survive then?

JAMES CROSBY: Interest rates would have to move up very, very significantly to get us to anything like the same interest rate stress that we had in the late 80’s – and that’s just not going to happen!

DAVID ROUGH: Last year you started underwriting the creditor insurance business yourself. With a slowdown on the way wasn’t that awful timing?

JAMES CROSBY: No – in fact it wasn’t that much of a change really – the nature of the arrangement we and other banks historically had with the insurers meant we were all but underwriting the business ourselves. So we don’t see that the move to actually being the repayment insurer has changed our risk profile. It has just given us more control, a greater ability to design the product to fit into our sales processes; and as a result we’ve achieved better sales. This is an important and profitable business, which is performing well without having a higher risk profile.

Do you really think you can double your SME business in three years?

DAVID ROUGH: Is Intelligent Finance ever going to earn an adequate return on capital for shareholders? Are you prepared to give a decade for it?

JAMES CROSBY: As a new bank, Intelligent Finance has done all the right things: built a brand, a very powerful consumer brand, in a key part of the market. We’ve built assets because you never turn a new bank round to profitability without doing so, that’s where the margin comes from and last year Intelligent Finance took an 8% share of net mortgage lending. We’re now building the volume to get to the required scale. The challenge isn’t when we break even, because I’m sure we’ll break even at the end of 2003. It’s the number of products per customer. Last year that grew from 1.9 to 2.2 which shows we are well on the way to getting the number of products per customer to the level that will deliver shareholder value.

DAVID ROUGH: But merely breaking even isn’t much of a goal?

JAMES CROSBY: That’s why I say breaking even at the end of 2003 is not a particularly exciting ambition. We will deliver it. But as I say, we’re much more focused already on driving up the number of products per customer.

DAVID ROUGH: You pay front line people very well, they appear to have share options, are you sure you’re not incentivising them to sell the wrong products?

JAMES CROSBY: Yes, they are incentivised to sell but it’s not just about sales; there are all sorts of quality measures as well. Remember also, our retail strategy is based on offering customers simple products, which offer value for money. That really does reduce the chances of mis-selling because the customer is so much more likely to really understand what he or she is buying and why.

DAVID ROUGH: How much shareholder value destruction is represented by the purchase of St. James’s Place Capital at the top of the market? And are you going to do anything with the minority interest?

JAMES CROSBY: St. James’s Place has a unique business model. It’s a wealth management business that actually does have real distribution, not just a nice idea waiting for customers to come to it. Inevitably, this sort of business was going to struggle in the third year of a bear market but as markets recover and we see the advent of a new depolarised world, St. James’s Place will return to its traditional growth track. When we bought the business we said it was right for us to own a majority stake. The fact that management and the financial advisers in St. James’s Place own their own bits of the business is part of its uniqueness. We think that’s still right today.

DAVID ROUGH: So is it an investment or a core part of HBOS?

JAMES CROSBY: Yes it is core to our strategy. We set ourselves the ambition to be if not number one, one of the two or three biggest players in investment products, a strategic imperative for an organisation that is already number one in liquid savings. To be number one in investment products you have to have wide-ranging distribution, in bancassurance, IFAs and upscale wealth management where St. James’s Place come into their own.

DAVID ROUGH: On its announcement in 2000 esure was responsible for a pound hike in the then Halifax share price. Three years on what’s happening, has it measured up to all the early hype?

JAMES CROSBY: It’s doing extraordinarily well, distributing through Halifax branches, Sainsbury’s stores and direct using the esure brand which has established itself as the internet/telephone motor insurance brand for safe drivers. It has a great opportunity to grow profitably in today’s insurance markets.

DAVID ROUGH: Are you out of with-profits? If not, why not?

JAMES CROSBY: Today with-profits products represent roughly 25% of all our investment sales and yes, it’s a market that currently provides an inadequate return for shareholders. We’ve said as much on a number of occasions. But the bear market has meant that capacity has been destroyed in this market in a way which will never come back. With fewer competitors, there’s every chance that this market will support higher returns in the future. But if it doesn’t we’ll redeploy our capital elsewhere.

DAVID ROUGH: But if Sandler’s recommendations are implemented won’t it make it impossible for you to earn higher returns and operate within a 1% fee cap?

JAMES CROSBY: We’ll wait and see if and how Sandler is implemented. There’s not a lot in Sandler that’s not already happening somewhere in the marketplace anyway. For example, the secret of our success in bancassurance is selling simple products with a single annual management fee which gives real value to the consumer. And yes, if the 1% cap is applied to with-profits they won’t be part of the simplified product offering Sandler so wishes to promote!

DAVID ROUGH: Can’t you build a sensible SME business without giving the product away? Isn’t that what “free banking forever” is all about?

JAMES CROSBY: We have made a big investment in building the capability and infrastructure to go into England and Wales precisely as we said we would. But we’ve also made great progress in attracting new customers – up 36% on last year to 273,000. The established order in SME banking has been operating in a cosy, frankly uncompetitive world. The result is, highly priced, confusing products delivered through inefficient systems.

There is a great opportunity for us in bringing together Bank of Scotland’s market leading capability in Scotland with Halifax’s distribution systems in England and Wales, to really make a difference for SME customers – providing a real choice; one based on simplicity and value and if value means “free banking forever” so be it, we’ll still make excellent returns for our shareholders.

DAVID ROUGH: Going into a market like this, are you not going to get the poorer risks rather than the better risks coming to you?

JAMES CROSBY: No – that’s where having the Bank of Scotland’s capability on the ground and being involved from top to bottom is so very important to us. This isn’t a business Halifax could have built on its own. Halifax just didn’t have Bank of Scotland’s pedigree and capability in business credit assessment. Equally, Bank of Scotland always lacked distribution power in England and Wales.

DAVID ROUGH: Do you really think you can double your SME business within three years?

JAMES CROSBY: Yes, that’s our target, from 3% to 6% market share and we’ll do it. We’ve already moved much faster in other banking products – products like current accounts where we were also told customers wouldn’t move.

DAVID ROUGH: Corporate banking – much has been talked about by other banks it is alleged, investing in quoted junk bonds. Given the poor business climate in the UK, is not the Bank of Scotland’s high exposure to highly leveraged MBOs – not just the same thing?

JAMES CROSBY: No. We don’t invest in junk bonds, we lend on a relationship basis on individually structured deals where we are in control of the lending mandate and judgement to a very large extent. The truth is our MBO portfolio is performing pretty well in line with the rest of our book at this stage.

Does HBOS fall foul of any of the Higgs recommendations?

DAVID ROUGH: Over the years, investors have watched Bank of Scotland consume capital like a thing possessed. With all this growth in Corporate it looks like business as usual now it’s HBOS?

JAMES CROSBY: Our Corporate team made great strides in 2002. They showed how returns in this business can be increased even when we’re suffering provisions significantly above any through the cycle average. And remember, it’s returns that matter, Corporate only wins capital allocation inside HBOS by delivering RoE!

DAVID ROUGH: You have significant exposures to split capital investment trusts and property. Time to be scared or are you still confident?

JAMES CROSBY: Our investment trust lending has halved as trusts have de-geared into the bear market. We’ve said we’ve made some provisions in this area but not material. Our property interests are very well spread, ranging from housing association loans through to property development. We don’t foresee a difficult cycle in commercial property but even so we’ve significantly managed down our exposure to riskier areas such as office developments in Central London.

DAVID ROUGH: And in terms of “stakeholder pensions”, do you believe that stakeholder is the panacea for either your savings and investment market or for your clients?

JAMES CROSBY: No, there’s a lot of evidence that you can CAT mark products, you can cap their charges and everything else and actually it doesn’t influence what people buy. Today, most of savings products that are or could be bought are CAT marked, but very few mortgages are CAT marked. What does that tell you? It tells you the consumer will engage with the bank or insurance company in the product they really want or need to buy regardless of whether or not it is CAT marked.

DAVID ROUGH: Corporate governance. My own personal view is that boards with over ten members do have real problems. How do you make a board of 17 function in a satisfactory manner?

JAMES CROSBY: Ours is a highly regulated and complex business. Our non-executives have to devote a considerable amount of time, not just attending main board meetings but working on the various committees and getting close to the business. We have six main Audit and Risk Control Committees and all the other committees you’d expect us to have. But you are right. If 17 people got together once a month and that was all they did, it wouldn’t work.

DAVID ROUGH: Therefore their roles and responsibilities are larger than you’d expect in most non-financial services companies and therefore they get rewarded sensibly?

JAMES CROSBY: Yes, our non-executive directors do give substantially more time, they get into the detail right across a complex business, they probably do have more responsibility and, yes, hopefully the rewards are about right.

DAVID ROUGH: And will your senior non-executive and other non-executives be attending all your meetings with investors, as the Higgs report suggests?

JAMES CROSBY: Probably not, but they’d be very welcome to attend all hundred plus of them that I do each year.

DAVID ROUGH: Does HBOS fall foul of any of the Higgs recommendations?

JAMES CROSBY: No! Because the core principle of Higgs is that it isn’t a set of rules, it is a benchmark against which PLCs that differ should argue confidently as to why their model is slightly different. The one key area where we’ll be different is that we have a chairman who is chairman of two FTSE companies. On each of the occasions the board elected Dennis Stevenson to be chairman they did so full in the knowledge that he also had the role as chairman of Pearson. His appointment has served the shareholders extraordinarily well. So why on earth would we change that?

DAVID ROUGH: Given the complexity of your business, are you and the senior management spending enough time ensuring that training and development goes on at all levels of your staff?

JAMES CROSBY: I believe so. There are phases in any merger; the first six months is putting people into jobs and helping them to work with each other. Then a year to 18 months on you really are immersed into all the succession planning and development, which are so important for the future. One of the most exciting things about our new organisation is the very high quality of people who are joining us. Internal development, succession planning and attracting top class talent into the organisation are all crucial to our future.

DAVID ROUGH: And in terms of succession planning the board takes succession planning seriously? And you’re being challenged enough in your position?

JAMES CROSBY: Oh yes!…Definitely!

DAVID ROUGH: Often, chief executives make sure that the next level down are open to challenge but avoid effective challenge to their own position?

JAMES CROSBY: If we’re judged to have been successful during my time as chief executive, my greatest ambition thereafter will be to pick up the newspapers and read about further success in the organisation. So yes, there’s plenty of challenge. I’ve got outstanding colleagues; colleagues who can take over from me any time.

What constitutes financial strength at HBOS?

DAVID ROUGH: Did you raise capital to maintain your credit ratings? Are you running this business so as to maintain ratings?

JAMES CROSBY: You can’t always sustain your credit rating through all market circumstances and you shouldn’t obsessively manage your business to do so. In our case though we are number one in liquid savings so financial strength is unusually important – it’s part of our brand.

DAVID ROUGH: Fine, but what constitutes financial strength at HBOS?

JAMES CROSBY: We would argue that we have the best balance of different businesses amongst our peers, we’ve got the capital we need to support growth, very high quality assets, two thirds of which are mortgages and unrivalled leverage capacity. So we’d be disappointed if they weren’t reflected in one of the best credit ratings in the market, as indeed they are.

DAVID ROUGH: And in terms of return on capital, your target in 2004 is for a 20% return on equity? It seems to me that investors simply don’t believe you can get there?

JAMES CROSBY: Yes, but with respect they’re wrong. Let me tell you how we’re going to achieve it. First of all we’ve just increased our Group Target Return on Equity by over one per cent in one year from 16.8% to 17.9%. And for the future we’ve got a lot going for us. We’ve got very significant merger synergies still to come through, around £600m. In 2002 we were still sustaining substantial losses in Intelligent Finance which we will eliminate. We will increase returns in a number of divisions as we also did in 2002.

But the key is Retail where we showed in 2002 how we can increase shareholder returns whilst giving better value to customers. We’ve achieved that through the virtuous circle of better products producing more sales, higher productivity, lower costs and so on. And for us that circle has much further to turn. So no shortage of reasons why we’ll hit 20% in 2004.

DAVID ROUGH: So presumably your costs have got to grow at 3 or 4% less than your asset base to enable you to achieve that virtuous circle?

JAMES CROSBY: Yes, indeed – look at last year, we had a slight slippage in margins in Retail but we still had a double figure percentage increase in revenue and we had just a 2% increase in costs. And yes, we can keep that going, maybe not forever but for a few years. Simple business, you drive revenue harder than costs, you drive up returns and the real trick in this marketplace today, you have to do it without widening margins. So we really do believe we can do more than just deliver our 20% RoE for shareholders – we can at the same time give better value to customers. That’s the nature of our ambition.

DAVID ROUGH: So over the next five years are you going to remain a UK company?

JAMES CROSBY: We have tremendous opportunities in the UK to grow the business in pretty well every product line. We’re no fans of expanding internationally for the sake of it and we will only make a major international move if it genuinely adds value for our shareholders, and if it’s big enough to matter for them. In the meantime, where we can we take our expertise abroad and add value for shareholders as we do in Australia, in Bank of Scotland Corporate Banking in the US or indeed investment products across Europe under the Clerical Medical brand.

DAVID ROUGH: Is there a share price at which the board would sanction buying your own shares in?

JAMES CROSBY: You are really testing our own ability to invest retained earnings at a good return. We’ve grown our return on equity this year, we’ve got a target out there to grow it over the next couple of years. So it’s clear that we can deploy the capital we’re generating in the business very profitably for our shareholders – regardless of short term volatility in our share price. So the answer to your question is clear – it’s no!

DAVID ROUGH: And are there two or three key financial measures which are in your control that you are happy to be measured by for the next three years?

JAMES CROSBY: Yes we’ve got lots of public targets, in fact more than the rest of the banking sector put together. But the two financial ones that loom largest for me are; the return on equity for 2004 and the tough cost targets we have for each division – targets which define what it is we have to achieve to win on costs.

DAVID ROUGH: And to deliver in terms of revenue growth I take it?

JAMES CROSBY: Yes we have market share targets in lots of products but I wouldn’t necessarily call them financial targets. But yes, having simple value for money products that customers buy in great volumes is critical – because that’s what enables us to deliver higher returns and lower costs without widening margins against the customer.

DAVID ROUGH: And if in 2004/2005 you failed to make that RoE target, will you consider it to be an act of God or would it be that the management have failed to perform?

JAMES CROSBY: It’ll be exactly what our shareholders tell us it is! If we hit the target the shareholders will be delighted, if we don’t the shareholders must sit in judgement, that is always their prerogative. I wouldn’t offer any excuses but if they want to offer excuses that’s fine by me.

What really motivates you?

DAVID ROUGH: Management often benefit by backing economic growth as if it’s all down to their genius whereas when it’s an economic downturn or somebody else’s fault it’s the world economy, it’s not their problem.

JAMES CROSBY: You make running a major PLC sound like being a politician! I’ve been chief executive of a PLC for four years, three of them have been in the worst bear market since 1974. I believe that our business is forging a great future for itself. But you are right, it’s a really tough environment in which to convince people that’s the case! We can only deliver a share price that does better than its peers and over the last three years it has by 25% plus, but obviously shareholders aren’t quite so impressed when the market has still dragged the share price down.

DAVID ROUGH: Are you in denial about the size of your pension scheme deficits?

JAMES CROSBY: No. Frankly, I think most of our deficits will be eliminated as and when markets recover. But even if I’m wrong the members of our schemes are young and, as our FRS 17 data shows, the long term costs of putting right the deficits are eminently affordable for HBOS.

DAVID ROUGH: Finally, what really turns you on? What motivates you? Is it the returns to shareholders and thus your pockets? Or destroying the competition?

JAMES CROSBY: Shareholders are our owners, ultimately we really only exist to create shareholder value. Sometimes the best way to make money for our shareholders is to make life tougher for our competitors’ shareholders. But that has always been the case. We believe that in today’s markets you can only achieve real shareholder value in financial services by being genuinely different. For us in Retail that means delivering value, simplicity and transparency to customers. There is no misalignment between the interests of shareholders and customers and you see that in our figures this year, very, very clearly. It is volume growth and profits growth on top of tight cost management in pretty well every business we’re in. But none of this could be achieved without the enormous efforts of our other stakeholders, my 60,000 colleagues. They’re the ones who really deliver for customers and shareholders.

David Rough asked that in place of a fee for this interview, a donation be made to Childline and The Salvation Army. The interview was recorded on Monday 20 January 2003.

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