A division of the former HBOS bank has been found guilty of "very serious misconduct" by the Financial Services Authority in a damning critique of the way it was managed in the runup to its taxpayer bailout and rescue by Lloyds Banking Group.
The Bank of Scotland division of HBOS only escaped a "very substantial penalty" because the taxpayer would have had to foot the bill. It is understood that the fine would have easily surpassed the £17.5m penalty slapped on Goldman Sachs for systems failures.
The FSA said BoS's corporate division ran an aggressive, high-risk growth strategy, prioritised optimism over prudence and sanctioned too many big loans to a small number of borrowers. It said the bank was too optimistic over bad debts and did not take "reasonable care" to control its affairs.
Business plans set ever increasing targets for profit growth in the corporate arm – and targets were increased during the first half of 2007 to "imprudent" levels as the group looked to the corporate division to make up for the underperformance of the retail arm.
As it appeared to set out a case to take enforcement action against the bank's management, the FSA's decision notice pointed to a "collective denial" about the impact of the financial crisis on the bank's corporate lending division.
While the FSA has closed its investigation into the firm, it stressed that "other enforcement proceedings in connection to the failure of HBOS are ongoing".
Tracey McDermott, the FSA's acting director of enforcement, said: "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."
The investigation into Bank of Scotland's corporate division dated back to the start of 2006, when the HBOS parent group was run by Sir James Crosby. He handed the reins to his protege Andy Horby in the summer of that year. The FSA's inquiry concludes at the end of December 2008 as HBOS was rescued by Lloyds. Lord Stevenson was chairman of the banking group throughout the period, while the corporate division was run by Peter Cummings.
Six paragraphs in the FSA's decision notice are redacted because of an ongoing police investigation into activities at an HBOS branch in Reading.
The enlarged Lloyds is 41% owned by the taxpayer, which pumped in £17bn of funds to buy shares. Andrew Tyrie, the Conservative MP who chairs the Treasury select committee, criticised the regulator for not publishing the fine it would have imposed. "From what we can tell, corporate governance was a shambles and needs thorough investigation," Tyrie added.
The FSA found that the BoS corporate division was focused on revenue rather than risk and incentivised staff to focus on the "development of relations" with customers. Risk management was regarded as a "constraint on the business rather than integral to it".
The bank failed to pull back on lending even when rivals were doing so and by April 2008, even though the bank knew some of its lendees were in trouble, it was too slow to classify them as "high risk". This meant that the full extent of the problems in the division were not made clear to the board, its auditors or its regulators.
When Lloyds stepped in to buy HBOS the enlarged Lloyds increased the level of bad debt provisions from £3.3bn at 12 December 2008 to £7bn by 13 February 2009. "[Bank of Scotland] consistently chose to provision at what [auditors] KPMG identified as being at the optimistic end of the acceptable range for corporate," the FSA said.
To illustrate the risks being run the regulator set out the exposure to commercial property, which was 52%, or £44bn of the corporate loan book at the start of 2006 and had risen to 56% by the end of 2008. There was also exposure to "single names", with the top 30 largest exposures accounting for 15% of the portfolio in 2006, rising to 23% by the end of March 2008.
Lloyds said the FSA action would "help to draw a line under the events in question and allow the group to move forward".