Careless lending at HBOS Irish division led to highest losses

Report notes the Irish banking market relied on informal connections

It's five years since the plug was pulled on the Bank of Scotland (Ireland) operation by Lloyds Banking Group, having racked up £10.9 billion (€15.53m) in losses. In the years before the 2008 crash, Bank of Scotland (Ireland) had expanded its business here aggressively, throwing shapes at becoming a major player in Irish banking.

A 400-page report published yesterday details the folly of this strategic decision, the lapses in oversight, and the failure of its UK parent, HBOS plc, to heed various warning bells about its Irish subsidiary.

The report by the Prudential Regulation Authority and the Financial Conduct Authority details the failure of HBOS in October 2008, leading to it being merged with Lloyds. It mostly focuses on the period from January 2005 to late 2008 but also goes back to the merger of Halifax and Bank of Scotland in 2001 to form HBOS.

Bank of Scotland (Ireland) was a large contributor to this failure, recording the highest losses of all the group’s divisions. This was in spite of it being part of the international division set up in 2004, which was the smallest within HBOS in terms of assets.

HBOS considered the expansion of its international unit as a diversification but the report states that this was not the case in Ireland.

“Ireland retained close links to the performance of the UK economy and financial system, with Irish banks significant investors in UK commercial property markets, and UK banks big investors in Ireland. Expanding in Ireland did not reduce the significant exposure to a downturn in the UK market.”

The report details how the bank emerged from the purchase of Equity Bank in 1999 and its later merger with the larger ICC Bank in 2001.

ICC Bank had concentrated on hotels, venture capital, SMEs, pubs, restaurants and commercial property.

Bank of Scotland (Ireland) later took on Halifax’s Irish mortgage portfolio and from 2004 pursued the development of a full branch network, offering customer accounts.

It was set on “changing the traditional competitive landscape and providing more attractive products” for customers than local operators.

The aim was to rapidly expand its retail and corporate businesses to become the third or fourth largest bank in the State within three to five years.

“Senior management [in HBOS] advised the FSA [Financial Services Authority] that this strategy was a repeat of their expansion experience in the UK following the 2001 merger, and that they would therefore leverage upon those experiences,” the report states.

However, it notes that the Irish banking market relied on informal connections between banks, borrowers and professional advisers such as accountants, solicitors and surveyors.

Bank of Scotland (Ireland) bought a network of showrooms from ESB and began transforming them into bank branches at a rate of three per month for 14 months from the beginning of 2006.

Aggressive growth

It also gained around 150 non-banking staff and a small finance loan book in the deal. The establishment of the branch network was designed to reduce its reliance on brokers.

“This was presented as an innovative cost-effective solution to rapidly achieve a substantial footprint upon which to pursue aggressive growth in market share,” the report says. “This seems to have been a high-risk strategy and it is questionable whether the risks were properly thought through.”

The report found that Bank of Scotland (Ireland) – which it refers to as BOSI – had an existing staff resourcing issue, without recruiting new employees and training the ex-ESB workers, all at a time of “planned rapid growth and expansion into new products”.

In addition, the infrastructure, governance and risk-management frameworks needed to be built out to accommodate the planned growth.

“Finally, BOSI would not initially be in a position to offer current accounts, and so would lack a potential early-warning indicator of troubles with its customers. In hindsight, this was a blueprint for rapid uncontrolled growth with inadequate risk mitigation.”

In spite of significant growth targets, HBOS did not set out risk-appetite statements for any of the international businesses at a group or divisional level beyond sectoral concentration limits.

Ireland was a high growth area for HBOS, with its loan book growing from £8.9 billion in 2004 to £30.7 billion in 2008. The FSA estimates that HBOS had achieved its goal of being the fourth largest player here by 2008.

In 2005, growth in new business volumes in Irish business banking was broadly in line with the market. By 2007, it was outstripping the market and its share in retail increased in both 2006 and 2007.

“A fall in fees behind plan and some slowing of activity in 2006 had led to a ‘… concerted effort to reinvigorate sales’ and loan growth for 2007, the peak of the market, exceeded that achieved in 2006,” the report notes. To gain market share, Bank of Scotland (Ireland) offered mortgage tracker rates between a half and one percentage point below the incumbents’ typical tracker and standard variable-rate offerings. It also offered 100 per cent loans during the boom years.

It had a high proportion of interest-only mortgages – almost 50 per cent for all mortgages and more than 90 per cent for the buy-to-let portfolio.

“The risk had been recognised in June 2006, when it was also noted that it made BOSI an outlier compared to peers,” the report says. But this was considered to be “largely a heritage issue”and the risk profile was considered to be good.

Even as house prices in Ireland fell by 7.3 per cent in 2007 and were predicted to fall by a further 10 per cent in 2008, the division only reduced its maximum loan-to-value ratio from 95 to 90 per cent, and its buy-to-let from 90 to 80 per cent.

In the early months of 2008, the Irish bank lagged the competition in raising margins and reducing commissions to brokers, who were also encouraging switching in an effort to stimulate volumes.

As a result, the bank gained unexpected market share, with new buy-to-let lending exceeding its product limit. By May 2008, buy-to-let lending had ceased but the portfolio was now about €1.2 billion, more than twice the size it was in 2006.

“This highlights the inherent risks of a broker-led mortgage business,” the report adds. “Without strong controls, a lender can be exposed to the risk that brokers have conflicting objectives leading to unplanned growth and excessive risk.”

In terms of commercial property, the Irish bank had €14.5 billion (with a commitment for another €1 billion) spread across property investment and development, construction, hotels and restaurants.

More than 40 per cent was to the higher-risk segments of property development and construction. Over half of the development exposure had interest roll-up facilities, with a significant proportion already in use by the end of 2008, while more than 50 per cent of the exposure was classed as land (about £2.5 billion), of which over half did not have planning permission.

“BOSI found itself particularly exposed as the oversupply of property became apparent, the market lost liquidity and the economy tipped into severe recession,” the report says.

The property development exposure was almost 22 per cent of the corporate portfolio and 15 per cent of the total loan portfolio. “This represented a reversal of the aim of the BOSI board, which in June 2006 had expressed a desire to reduce the property development component to 10 per cent of the total book.”

As a result, development exposures more than doubled from €2 billion to €4.8 billion in just over two years.

The report states that the Irish Financial Services Regulatory Authority limited property exposures to 250 per cent of a bank's capital base. However, in the case of Bank of Scotland (Ireland), this did not apply as Bank of Scotland in the UK provided a guarantee that took the risk on to its balance sheet.

“This enabled the property exposures to grow excessively.”

At the end of 2007, the capital base of the Irish division was around €2 billion, which implied a property limit of €5 billion, but the guarantee meant that actual property lending (excluding hotels and restaurants) was at about €11 billion.


An expectation of further property lending in 2008 led Bank of Scotland to increase the guarantee in late 2007. By the end of 2008, property lending had increased to €12 billion.

The Irish bank’s hotel lending at £1.2 billion was also vulnerable to the downturn. Remarkably, the bank had lent on about one-third of all hotels in Ireland by 2007 and seven borrowers accounted for 69 per cent of its exposure by the end of 2008.

“Of these, around a half were barely earning enough income to cover interest charges,” the report says, adding that lending was often at 100 per cent loan to value. “This left BOSI exposed to even a small fall in prices, let alone the significant falls that were actually experienced.”

The report also details how the size of its large exposures increased in a short space of time. At the end of 2006, the bank’s largest exposure was £100 million. Between June and August 2007, Ireland significantly increased the value of the deals it was prepared to do, with its top five exposures increasing from around €500 million in aggregate to about €2 billion. These were “heavily biased” towards commercial property.

When the crash came, the Irish bank was was badly exposed. Its impairment losses grew from £22 million in 2007 to £2.9 billion in 2009 and £4.3 billion in 2010.

The losses were dominated by corporate lending, which accounted for 90 per cent of them. More than 80 per cent of its corporate assets became impaired, with under 40 per cent expected to recover.

Around 15 per cent of Irish retail assets have become impaired with recovery rates expected to be even lower.

The Irish corporate losses were due to a preponderance of commercial real estate lending: entered into at the height of the market; to large individual property developers who got into difficulties as the bubble burst; and on aggressive terms with weak security.

The report states that while the downturn in Ireland and the subsequently declining asset values played a significant part in the bank’s losses, “weak controls exacerbated the losses”.

For example, the Irish bank allowed brokers and borrowers to choose valuers from a panel to provide valuations on mortgaged properties, giving rise to “over-inflated valuations” used to make lending decisions.

Within the corporate portfolio, a 2009 file review covering 37 per cent of the outstanding portfolio found widespread failings in credit controls before 2009. These included: insufficient challenge of credit proposals within BOSI, evidence of credits being sanctioned despite indications that the client was untrustworthy or that the sanctioning authority did not understand the submission, limited annual review of existing loans, credit files rarely complete or not containing up-to-date relevant information, and the use of internal valuations by BOSI rather than independent professional valuations, even for highly specialised areas such as petrol stations and wind farms.

The review noted that some of these valuations included “hope value” – optimistic assumptions made about the use of land when planning applications had already been rejected.

In May 2005, HBOS’s group board reviewed a number of papers related to Ireland. Two of them raised concerns around the level of credit knowledge, resource, and systems and controls to support growth plans.

In contrast, a third by the Bank of Scotland (Ireland) chief executive stated that “BOSI has taken advance steps to ensure effective risk management commensurate with this level of expansion”. This suggested the issue had been dealt with but “this apparent contradiction should have prompted some challenge”, the report says.

A May 2006 board paper from the risk function noted that “although the current level of arrears for each portfolio is monitored, there is a risk that problems could be disguised by rapid growth and the relatively high proportion of immature business”.

The report also deals with the FSA’s supervision of the Irish business. Its supervision team was concerned about controls in the Irish business due to its rapid growth. Records were found of two visits to Ireland by the supervision team in March 2006 and December 2007.

“The supervision team’s discussions about the Irish business were characterised by reassurances from senior management that the risks were being managed,” the report states.

Following a review in 2005, Bank of Scotland (Ireland) told the FSA its retail expansion had been “completely re-planned”. The supervision team was also informed in February 2006 that group risk went to Ireland fortnightly to oversee progress.

It all counted for nothing when the crash came in 2008. Like the Titanic hitting the iceberg, it was merely a question of when the bank would sink without trace and the size of the losses.

Ciarán Hancock

Ciarán Hancock

Ciarán Hancock is Business Editor of The Irish Times