HBOS and the imagination for disaster

Remember HBOS? Last week, the Financial Services Agency belatedly censured the failed bank and its management for a long list of regulatory failures.

The agency had wanted to impose a financial penalty "proportionate to the misconduct identified". However, it declined to do so. The bank is now in government hands and a fine would amount to nothing more than one arm of the public sector taking money from another. A penalty would only further burden the taxpayer and HBOS has already royally screwed us financially. "Why make it worse?" The FSA reasoned.

Regrettably, the FSA didn't grasp the symbolic importance of punishing HBOS. Sure, it would have meant taking money out of one pocket and putting it into another. Nevertheless, a massive fine would have set a precedent. It would have given other lawless bankers a reason to pause and think. The FSA lacked the imagination required to understand the pain of UK tax payers. It couldn't understand that we, the taxpayers, need to see some accountability. To achieve this accountability, there is sometimes a need for gestures. Instead, all we are going to get is a bureaucratic report from the FSA. It is not nearly enough.

The FSA report may be an inadequate response to the magnitude of the financial costs imposed by the HBOS failure, nevertheless, it is a grim read. It described, in harrowing terms, the unalloyed incompetence of those running the bank prior to the crisis. In particular, it was HBOS management's misguided "aggressive growth strategy, with a specific focus on high risk, sub investment grade lending" that paved the way for the bank's collapse.

According to the FSA, the Corporate Banking Division was the unit most culpable for sending HBOS down the toilet. This division concentrated its lending in the over-inflated commercial property market. .At the start of 2006, commercial properly accounted for 52 percent of Corporate Banking Divisions loans. By the end of 2008, this proportion had risen to 56 percent. Those ratios miss the real story. In early 2006, the Corporate Banking Division had written loans amounting to £44.4 billion; by the end of 2008, this amount increased by over 50 percent to £68.1 billion. Moreover, most of its lending was to large clients.

This was a poisonous mix; over-valued assets and a limited number of over-leveraged clients. Corporate Banking constructed a portfolio that virtually guaranteed a massive stock of bad loans the moment the economy slowed. To put it more starkly, the Corporate Banking Division had made the most basic banking mistakes in the book. It was kindergarten banking.

Meanwhile, back at bank headquarters no one was paying attention. There were no credible risk assessments, control frameworks, or attempts to identify transactions that were going wrong. Headquarters didn't even have any reliable "management information". That is business-school-speak meaning that the management didn't have a clue what the Corporate Banking Division was doing. The HBOS board let this Division run amok, and so long as it was turning a profit, it couldn't care less. A less forgiving observer might conclude that the bank was playing the financial equivalent of Russian roulette.

Within the Corporate Banking Division, the FSA reported that there was a surreal sense of optimism. The bankers could not conceive of a financial crash. Things could only get bigger and better. The only world they understood was one where they wrote up high risk loans, received bonuses, and partied like it was 1999.

However, the world turned on HBOS and its delusional bankers. The first signs emerged in the summer of 2006, when property prices started to wobble in the United States. By early, 2007, everyone had heard of subprime. By the middle of 2007, you would have to be self medicating not to notice that UK commercial property prices were over-valued.

Nevertheless, HBOS management paid no attention to any of that. It wasn't as if they weren't told that there were problems. Management ignored repeated warnings from their divisional risk unit. They even fired a risk manager who dared suggest that the bank could run into problems. They even disregarded the advice of their auditors, who meekly suggested that the level of their bad loan provisioning was too optimistic. Presumably, HBOS thought that with sufficient gung-ho optimism, they could inoculate themselves from the growing financial crisis. They simply believed what they wanted to believe and ignored anything that might impinge on their detached world of hyper-inflated bonuses and high risk loans that could never go bad.

By April 2008, HBOS was in deep trouble. Many of its big clients were finding it difficult to pay back their loans. The sensible thing to do at that time would have been to get on top of the problem and manage down the risk. However, that would have required a cultural revolution within the organization. The high-risk lending would have to stop. Instead of dreaming of on their annual bonus, management would have to worry about the survival of the institution.

Even at this late moment, HBOS management wretchedly failed to meet the challenge. Time and again, it was unwilling to quantify its bad loan portfolio. They prevaricated, and refused to acknowledge the magnitude of the problems facing the bank. The lending didn't stop. As market conditions worsened, HBOS continued with their aggressive growth strategy. As the world outside was turning nasty, no one in HBOS wanted to know. Optimism prevailed over prudence.

In financial markets, no one was buying the bull from HBOS. A whispering campaign began, HBOS was in trouble. The rumours were soon reflected in the share price, which started to slip southwards. It didn't take long for financial markets to understand that HBOS was dying.

With this sorry tale in mind, consider the following thought experiment; imagine yourself as a HBOS banker in 2008, as the bank was going down in flames.

Before the crisis, you would have felt pretty good about yourself. You were highly paid; the bank you worked for was growing, and the future looked bright. The office culture, I suspect, would have been elitist, complacent and self satisfied. There was no place for naysayers. These were the perfect ingredients to create an environment for ignoring the warning signs of impending disaster. Would you have been able to see it, though?

Throughout 2008, the bank was slowly strangled, and you would have been in the middle of it. With each passing day, your world would have flaked away. But would the dreadful news from outside have shaken the optimism that underpinned the “aggressive growth strategy"? Would you have replaced that feel good optimism with a realization that HBOS was going to die? What was the moment, I wonder, when you understood that the end was close? I bet it was very late, perhaps only days before the end.

As the FSA report implies, the jokers running the bank didn't have the creative mindset for disaster. HBOS management just couldn't see the crash coming. They were blinded by percentage growth rates and what they meant for their personal remuneration packages.

How long is it since HBOS failed? To tell the truth, I can't quite remember when it actually went under. I am, however, more certain of its significance. It reminds us that people are greedy, and that when we are making lots of cash, our judgment often becomes warped and distorted. We develop something called "confirmation bias"; we fade out bad news, and select only that information that corroborates what we want to believe. The only antidote to confirmation is an imagination for failure. We need the wisdom to foresee an impending disaster. W need to think through what could go wrong, and to take evasion action.

For that, one needs dissenting voices. We need people to tell us that the world keeps turning, and that fortune can turn against us.