How Crosby braved the Arrows but then fell on his own sword

As the FSA probed risk-taking at HBOS, the bank's chief was sitting on its board. Richard Northedge charts the events that were to bring him down

The surprise was that Sir James Crosby was ever asked to join the board of the Financial Services Authority (FSA) at all. Before his appointment in January 2004, he was not only chief executive of the HBOS banking group but also the City regulator's official critic.

As a member of the state-backed Financial Services Practitioners Panel, he scrutinised the watchdog and highlighted its inadequacies, often in colourful terms. Indeed, the panel's final report before the critic switched sides featured a scathing attack on the FSA's Arrow reports – the detailed risk assessments designed to identify potential disasters.

"The FSA must appreciate that the Arrow process is based on its own assessment of the risks," said the 2003 report. "This may cause disagreements between practitioners, who face real commercial pressures, and the FSA over the relative importance of concerns raised by Arrow and over the proposed risk-mitigation tools."

But at this very time, Sir James was enmeshed in his own disagreement with the FSA over an Arrow report, caught himself between commercial pressures and a snarling watchdog. The regulator had launched a full risk assessment of HBOS in 2002 that identified a need to strengthen its control infrastructure. The FSA was so concerned, it used its powers under the Financial Services and Marketing Act to send in investigators to produce a further report. This revealed a need for improvements in HBOS's risk management.

Yet during this time, Sir James was recruited to join the FSA board as a non-executive director. And after 11 months of combining his role as regulator and head of Britain's biggest retail bank, he chose to sack Paul Moore, the head of regulatory risk at HBOS, provoking Moore to complain to the FSA about the group's ability to cope with risk.

The FSA asked the bank's auditor, KPMG, to investigate Moore's allegations and the firm interviewed Sir James, among others. Ironically, Moore used to be a partner with the accountancy firm, but the report found no evidence that he was dismissed because of his warning. Even so, the regulator continued to pursue its concerns about the bank's risk management.

At the end of June 2006, the FSA sent HBOS a new Arrow assessment saying there were still risk issues and progress would be tracked closely. It specifically warned that the bank's growth strategy posed risks that had to be managed and mitigated.

But Sir James had already made plans to quit HBOS in July. He stayed with the FSA while leaving the regulation problem with his successor, Andy Hornby.

Sir James cannot claim he did not understand the figures; numbers have been his life. The son of a Leeds tax inspector, he excelled in maths when sent to grammar school in Lancaster and read the subject at Oxford before taking exams to become an actuary. He joined Scottish Amicable in Glasgow, spending a decade assessing life assurance risks, and then another decade in fund management, analysing balance sheets and grilling bosses.

His "JRC" personalised number-plate is an unusual show of vanity for someone who says weekends off are his greatest pleasure. The man who said he enjoys watching "the least-demanding television programmes I can find" is now senior non-executive director at ITV.

He still lives in his native Yorkshire, having returned there in 1994 to head the Halifax Life subsidiary of the then building society. He quickly came up against regulatory standards, how-ever. The 600-strong sales force was forced to stop selling pensions, unit trusts and other investments for two months while it was retrained. This was an ominous early warning of the sales-based culture at the bank, which would go on to become HBOS .

And after the building society was floated, with Sir James appointed chief executive at just 42, the pressure to grow became greater. The Halifax was losing its market lead in mortgages and the falling share price left his own options worthless.

He toyed with using a £3bn war- chest to buy the beleaguered Barclays but ended up returning the cash to shareholders, running down the Halifax's capital reserve. Then in 2001 Bank of Scotland became available.

The merged HBOS was heralded as a new "fifth force" to take on the big four banks and, with Sir James in charge, it started an aggressive expansion with a simultaneous mortgage war and a competitive thrust on current accounts. The head of Nationwide building society wrote to Sir James claiming he was not leading the market but misleading it.

And while the Halifax shunned corporate lending, HBOS aggressively backed buyouts and bids including Sir Philip Green's £10bn attempted takeover of Marks & Spencer. It funded property ventures and bought US mortgage securities, doubling its asset base to £666bn between 2002 and 2007.

No wonder the regulators were worried at the rate of expansion. Moore says: "It was a major change – from a fuddy-duddy, musty old place to a shopping centre – to a supermarket-type culture." Indeed Sir James had turned to the supermarket world for the man to head the retail expansion. Hornby, at 32, was the youngest FTSE director when recruited from Asda.

Moore says the emphasis on sales was at the expense of risk, but while the lending was retail, HBOS increasingly used wholesale money markets to fund it.

And the bigger the bank became, the more it found it hard to meet regulatory standards. The month before Sir James was recruited to the FSA board, the watchdog fined HBOS's St James's Place subsidiary £25,000 for keeping inadequate records. The very month he joined, Bank of Scotland received a £1.25m penalty for breaching money-laundering rules.

But the FSA's main worry remained risk management at its new director's bank, and the concern heightened when the sacked Moore made his allegations. HBOS abandoned its profit targets and slowed its asset growth, allowing market share to fall, but a continued programme of share buy-backs eroded it's capital base, leaving it vulnerable when the bubble burst.

Sir James had no job to go to when he left HBOS in 2006, and the Government asked him to chair its inquiry into ID cards. Though branded an ally of Gordon Brown, he has proudly boasted of voting Tory all his life. In November 2007, however, Brown promoted the now-knighted Sir James within the FSA to deputy chairman – even though the effects of banking over-expansion were already becoming evident, with the credit crunch claiming Northern Rock.

If that was a surprise, it was even stranger that Sir James was asked by Chancellor Alistair Darling last April to produce a report on ways to restart mortgage lending. The former HBOS chief was already seen as part of the problem rather than the solution.

And there was concern that his influence was too evident in last year's FSA bans on short-selling. The first ban, on shorting shares in companies making rights issues, was designed to rescue HBOS's £4bn summer equity offer, and the second, covering all banks, coincided with Lloyds TSB's bid for HBOS in September and the Government's capital injections.

The initial ban was agreed at an emergency FSA board meeting on 12 June. Although it was held by conference call, the deputy chairman was absent, but the minutes state: "The board noted the comments of James Crosby provided in advance."

The 18 September emergency board meeting was held at Canary Wharf and attended by Sir James. Minutes say directors declared their interests, but one critic said last week: "Both those temporary bans were introduced to protect HBOS; there was no help for non-banks."

Sir James severed his link with finance when he resigned his £66,000 FSA post last week, but he remains the senior independent director at the Compass catering group as well as ITV and is due to become chairman of the Misys software firm this summer.

He should prepare for another appointment soon. The Treasury Select Committee to which Moore repeated his allegations now realises that despite grilling Hornby last week, Sir James was the architect of HBOS's downfall.

Committee chairman John McFall and Sir James are old adversaries. McFall has used his star chamber to harangue the banker on subjects from credit card rates to cash machine charges. At one grilling, McFall accused him of "skimming money off poorer customers".

But when Sir James faced the committee just before he left HBOS, the MP wished him every success on his retirement. He cannot expect McFall to be so gracious about his departure from the FSA. There are questions to be answered.