Why the FSA believes that HBOS should police itself

By Kenny Kemp

Published: Sunday Herald

Date: March 8th, 2009

The FSA’s decision to allow HBOS the same level of self-regulation as the healthy Barclays just months before its collapse and takeover appears to be an extraordinary lapse of judgement by the regulator. By Kenny Kemp

THE FINANCIAL Services Authority gave HBOS a gold-plated level of regulatory clearance just months before the bank’s collapse.

The Sunday Herald has learned that HBOS was one of only two banks (the other being Barclays) that was given “advanced IRB status” under Basel II guidelines — the laws balancing risk exposure against capital reserves — which allowed the bank to police itself and carry out its own financial “stress testing” without regular FSA inspection.

The concessions were granted after FSA inspectors carried out extensive work and gave the bank the all-clear, allowing it to continue to monitor itself.

Under Basel II, complex financial organisations can apply for IRB, or the Internal Ratings Based approach, the starting point being foundation (FIRB) and the highest level being advanced (AIRB).

This clearance now appears to be an extraordinary lapse by the UK regulator, for within a matter of months HBOS’s spectacular collapse precipitated the UK banking crisis and the forced merger with Lloyds TSB.

The new Lloyds Banking Group has since revealed massive losses inside HBOS caused by risky deals and it has now been forced to sign up to the government’s asset protection insurance scheme. The group is now more than 60% owned by the UK taxpayers, with £250 billion of toxic debt underwritten by the public purse.

This is a massive fall for Lloyds TSB, which this time last year was one of the country’s most prudent and successful banks. It also raises renewed questions about the precise involvement of Sir James Crosby, the former HBOS chief executive who was appointed by Gordon Brown, when chancellor of the exchequer, to be vice-chairman of the FSA, before he was forced to step down recently.

Last night, the FSA refused to comment on “individual companies and their relationship with the FSA”.

However, a spokeswoman confirmed that under Basel II’s IRB, banks were able to monitor their own risks and set up their own modelling related to capital ratios.

An essential element of gaining AIRB is that the board understands the bank’s risk profile. HBOS was only granted AIRB on January 1, 2008 and declared this as an important measure when raising their rights issue in the summer of 2008.

Mike Ellis, group finance director of HBOS, confirmed the status in April last year. On April 2, 2008, Ellis told investors at a Morgan Stanley conference in London that, while the economic situation was worsening, his bank was “conservative” with its risk.

Talking about the bank’s capital strength, he said: “Under Basel II, we have achieved advanced status for operational and credit risk and have adopted a conservative approach to the development of our credit risk models.”

The regulatory authority in the UK for the implementation of Basel II is the FSA. Ellis said HBOS was aiming for Tier I capital between 7.5% to 8.5% “adopting the same mid-point for Tier 1 of 8% under Basel 1”.

He added: “Maintaining strong capital ratios is a given at HBOS and we will not compromise in this regard.” And he went on: “One of the key tenets of liquidity management is not to take unacceptable credit risks, accepting that you cannot eliminate entirely credit risk, and we are very confident regarding the credit quality of our portfolio.”

Ellis also said that HBOS’s asset-backed securities were given “an overwhelmingly AAA external rating”.

This now seems extraordinary given subsequent revelations about the bank’s huge exposure to the money markets which all but destroyed the institution.

Ellis said: “This is a good quality book and, while it may be less liquid other than through repo markets, we expect to recover these negative fair-value adjustments.”

Ellis said he still predicted economic growth in the UK of around 1.7% and “we should still expect some modest easing in UK interest rates”.

The HBOS finance director mirrored the viewpoint of Eric Daniels, the Lloyds Banking Group chief executive, when he concluded that HBOS had “an unashamedly cautious approach, but very prudent and sensible in current market conditions, particularly when we do not expect to see securitisation markets open in 2008”.

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