The Co-Op story: a tale of two banks
This is the text of a speech given by Frances Coppola at the UK Society of Co-Operatives Conference on September 7th 2014 at the University of Essex.
The story of the Co-Op Bank is really
the story of two banks: the Co-Op Bank itself, of course, but perhaps even
more importantly – the story of the Britannia.
The Britannia story
The Co-Op Bank is not, and never was, a mutual or a co-operative. It is a plc. It was until its failure 100% owned by a co-operative, namely the Co-Operative Group. But the Co-Operative Group's ownership of it was on a limited liability shareholding basis. Co-Op Bank Customers were customers, not members: they did not, and do not, own the bank.
But Britannia was genuinely a mutual. It had successfully fought off an attempt by carpetbaggers to demutualise it in 1999. It remained in mutual ownership until its merger with Co-Op Bank, when its members became members of the Co-Operative Group.
Co-Op's heart is in Manchester, the Britannia's heart is in Leek.
The Leek and Moorlands Building Society was founded in 1856, only 12 years after the Rochdale Pioneers. It grew quickly, and by 1921 had assets of over £1m, which for those days is rather a lot. A series of acquisitions followed, including the Oldbury Britannia building society in 1975. It was after this acquisition that it changed its name to Britannia. But despite gobbling up an impressive number of smaller societies, it remained headquartered in Leek and primarily served the people in that area.
In 2005 it took over the Bristol &
West Building Society. Yes, I know you thought that went to the
Bank of Ireland. So it did. The 2005 purchase was of the Bristol &
West's savings & loan business and its branch network. The
mortgage book went to Bank of Ireland. Basically, Britannia
participated in the asset-stripping of a former building society that
had – like so many others - unwisely demutualised. It was a sign
that perhaps things at the Britannia were not quite as they should
In fact we now know that the Britannia
was doing what all too many banks and building societies were doing
at that time. It was lending larger and larger volumes at ever higher
risks, principally against property – both residential mortgages,
including significant amounts of subprime, and commercial property
lending. It also had a growing portfolio of commercial loans. With
hindsight, it is hard to see the purchase of the savings & loan
book from Bristol & West as anything other than an attempt to
improve its stable funding and disguise the true riskiness of its
But it was too late. The quality of the
Britannia's loan book deteriorated sharply in the financial crisis as
property values collapsed. By the end of 2008, both its subprime
mortgage book and, more importantly, its commercial property loan
book were severely impaired. As a mutual, it could not easily raise
new share capital to cover these impairments – but if it did not,
then losses would fall to the depositors, necessitating a bail-out by
the FSCS.* Andrew Bailey of the PRA, speaking in February 2014,
observed that the FSCS at the time did not have sufficient funding to
cover the Britannia's potential losses. If it had failed, other banks
and building societies would have been called upon to fund the FSCS,
which would have caused further distress and possibly more bank and
building society failures across the industry. It's worth remembering
just how big the Britannia was. At the time of the financial crisis
it was Britain's third largest building society, with assets of over
£33bn. In its 2008 report and accounts, it described itself as
“Britain's best mutual”, and congratulated itself on having
weathered the financial crisis without mishap.
A very strange merger
In October 2008, the Co-Op Bank opened
negotiations with the Britannia about a merger. The timing of this is
interesting. In October 2008, the world was reeling from the failure
of Lehman Brothers in the United States. Financial institutions of
all kinds were collapsing and financial markets were frozen. In the
UK, RBS was on the point of bailout, HBOS had been forced into a
disastrous merger with Lloyds, and Bradford & Bingley had been
nationalised. That is by any standards a very strange time to open
negotiations voluntarily about a merger, and I do wonder if the Co-Op
Bank was encouraged to do so by the FSA. Andrew Bailey's remarks
suggest that the FSA may have known the Britannia was in trouble and
was trying to find a way of saving it. If so, then the similarities
between the HBOS/Lloyds merger and Britannia/Co-Op are indeed
striking. Mergers are not always the best way of dealing with failing
The merger was presented to the world
as a love match. The partnership with the Co-Op would allow the
Britannia to offer a wider range of banking services to its
customers, including current accounts (since the Co-Op is a clearing
bank), while the Co-Op would benefit from access to the Britannia's
customer base to cross-sell other financial services.
The Co-Op Bank was less than half the
size of the Britannia, with assets of just under £15m. “Giant-killing” was a feature of the
Co-Operative Group's strategy: the merger with the Britannia fitted
nicely with that. But it appears that due diligence was, shall we
say, sketchy. KPMG warned the Co-Op that they were denied access to
crucial documentation, particuarly regarding the Britannia's
commercial property lending portfolio. Despite this, however, JP
Morgan, engaged by the Co-Op Group to advise on the merger, told
Co-Op Bank management that the merger should go ahead. Questions have
been asked about the perverse incentives offered to JP Morgan, who
were in effect paid to advise that the deal should proceed.
The merger was completed on August 1st
2009, and Neville Richardson, the last CEO of the Britannia, became
CEO of the enlarged Co-Op Bank. David Anderson, the previous CEO of
the Co-Op Bank, left. No reason was given then or since for the
Group's decision to replace Anderson with Richardson.
Richardson remained in post for the
next three years. The two organisations remained largely separate:
the synergies that the merger was supposed to bring never
materialised. To this day, the Britannia remains the local building
society in Leek. When plans were announced early this year to
complete the integration of the Britannia into the Co-Op, merging the
head offices and closing duplicate branches, there was considerable
concern among people in Leek. They were gutted that its name was
about to disappear, and horrified that jobs of local people were at
risk. They still find it hard to believe that the Britannia was the
cause of the collapse of the Co-Op Bank.
We now know that during Richardson's
tenure, the quality of the loan portfolio for both Britannia and the
Co-Op Bank deteriorated considerably. But it seems that he didn't
know – or if he did, he deliberately concealed it. In the 2011
full-year report & accounts, the last under his leadership, an
astonishing £3.5bn loans out of a total loan portfolio of £11bn
were described as “unrated” for credit risk. That is nearly a
third of the loan portfolio.
After Richardson's departure, probably
prodded by the FSA which had already expressed concern about the
bank's capital position, the bank embarked on a detailed review of
its loan portfolio. By the time of the 2012 full-year report, the
number of “unrated” loans had declined to
£2.6bn out of a total portfolio of £11.4bn, slightly less than a
quarter. But loans in default had more than doubled, from £921m to
just under £2bn. To be fair, the majority of these (£1,424.1m) were
in commercial property investment, and were downgrades of loans that
had previously been rated as "good" or "satisfactory".
But it is simply not credible to blame such a massive increase in
defaulted loans entirely on the economic climate. The fact is that in
2011 the Co-Op had a large number of loans that it either hadn't
assessed for credit risk at all, hadn't reassessed recently despite a
deep recession, or had assessed far too optimistically. The
Co-Op under Richardson was not in control of its loan book.
In February 2013 the Prudential
Regulatory Authority warned that the Co-Op Bank would need more
capital. This was followed in April by the Co-Operative Group's
abrupt decision to pull out of the Verde deal. By May, the wheels
were coming off. Moody's downgrade of the bank by six notches sparked
a run on its subordinated debt, causing a collapse in its bond price
and enabling hedge funds, which specialise in buying distressed debt,
to take a position. The bank admitted that it had a capital hole
thought to be of around £1.5bn. In the end it turned out to be
A walk through a bank balance sheet
So how could such a large hole in the
bank's capital appear so suddenly, and why did this mean that the
bank couldn't continue to operate?
First, I need to explain what bank
capital is. Here's a (simplified) bank balance sheet:
Assets on the left are made up of:
reserves – which are the bank's cash balances at the Bank of England
liquid assets – gilts and other securities that can be easily sold to raise cash to meet payment obligations
loans and securities – by far the largest proportion of bank assets
Liabilities on the right are made up
bonds in issue
short-term wholesale funding
The difference between assets &
liabilities is the bank's equity. This is of course a shareholder
model: the bank's equity is its shareholders' funds. If this were a
mutual, the equity would be the members' contribution (see footnote).
In the case of the Co-Op, there was a
layer of what we might call “mezzanine debt” between the
liabilities proper – deposits, senior bonds and other funding –
and the shareholders' funds. This consisted of preference shares
issued by the Co-Op Bank itself, and Permanent Interest-Bearing
Shares (PIBS) issued by the Britannia. Preference shares and PIBS are
forms of debt that are convertible to equity in the event of
insolvency. In other words, the holders can lose their money. And
because these are regarded as investments rather than deposits, they
are not eligible for deposit insurance.
The Britannia's PIBS were the lion's
share of these instruments, and they had been sold to Britannia
customers – mainly elderly people looking to boost their pensions –
as higher-yielding alternatives to deposit accounts. These people
were not told that these investments were less safe than deposit
accounts. When the Co-Op Bank took over Britannia, it took the PIBS
on to its own balance sheet.
So now we understand how the Co-Op
Bank's balance sheet was structured. Now we need to look at how the
capital hole developed.
The combination of equity and "mezzanine" debt is known as the bank's “capital”. It is divided into Tier 1 capital, which is shareholders' funds, and Tier 2, which is debt convertible to equity.
Here's a diagram showing how losses gradually "drown" a bank's capital. I've only shown the liability side of the balance sheet, and I've inverted the liabilities stack to make the "drowning" effect more obvious. The figures are for illustration only.
Losses generally stem from impairments to the bank's loan portfolio. As expected defaults rise, the value of the loan portfolio diminishes. The difference between the book value of the loan portfolio and its impaired value – roughly, book value less expected defaults – is taken to profit & loss. This means that the bank must “set aside” money to plug that gap, which otherwise would have formed part of its profits. If the amount required for impairments exceeds the bank's profits, it makes a loss. When a bank makes a loss, that immediately reduces its equity.
If impairments continue to rise, eventually the equity will be completely used up. The next part of the balance sheet to be drowned is mezzanine debt – in the case of the Co-Op that is PIBS and preference shares. Only after all of this has been wiped out would depositors and other unsecured senior creditors be at risk. A bank whose losses are so large that depositors and senior creditors are at risk is insolvent.
Regulators set minimum requirements for
the ratio of capital to assets. In its 2013 interim results, the
Co-Op Bank reported its Core Tier 1 capital ratio as 4.9% and its
Basel III CET1 capital ratio as 3.2%. This was below even the capital
standards prior to the financial crisis, and far below the PRA's
minimum requirements at the time of disclosure. It is what is known
as “regulatory insolvency”. The bank was not bankrupt, but it was
no longer safe for customers and could not therefore be allowed to
continue trading. It either had to raise more capital or be wound up.
The Co-Op Bank's capital hole developed partly as a result of realistic reassessment of the state of its loan
book, and partly from accelerating losses on commercial property and
commercial loans due to the economic climate at the time.
The hedge fund saga
Clearly, as I have
shown, both the shareholders and the mezzanine debt holders were
going to take losses. But who were the shareholders?
Remember that the
Co-Op Bank is a plc. Its shareholder – at the time it only had one – was the
Co-Operative Group. And because of the rules of limited
liability, the losses of the Co-Op Bank over and above its
shareholders' equity could not be forced on to the Co-Operative
Group, let alone its members. In short, the Co-Operative Group was
under no obligation to bail out its bank.
Had the FSA in 2012 followed through on its threat to change the regulatory categorisation of the Co-Operative Group to a “financial conglomerate”, then the Co-Operative Group could have been forced to recapitalise the bank. But because the “financial conglomerate” was Co-Op Financial Services (Co-Op Banking Group), which was as bust as the bank, regulators had no power to force losses on to the Group.
recapitalisation proposal originally outlined by the Co-Operative Group would have
involved some additional capital being provided by the Group. It also
involved the wiping of all subordinated debt holders, who would incur
very substantial losses. The proposal would have meant the Group
remained as majority shareholder.
Needless to say,
none of the subordinated debt holders were happy with this.
Institutional investors asked questions about the veracity of the
numbers: representatives of small investors argued that the
subordinated debt had possibly been mis-sold. In the end, it took two
hedge funds who had bought subordinated debt during the run on it
after the Moody's downgrade to resolve the situation. They put
forward an alternative proposal in which the subordinated debt
holders were bailed in rather than wiped, essentially becoming the
owners of the bank. In the end a deal was done that left the
Co-Operative Group as the majority shareholder with a 20% stake.
No-one was very happy with this, but it was better than the
alternative, which would have been for the Bank of England to take
over the Co-Op Bank and wind it up.
So where are we
now? The Co-Op Bank remains a plc, now with a very diluted ownership.
The Co-Operative Group still has a controlling interest, just about,
but only if none of the shareholders form themselves into a
consortium or sell out to a single organisation. The Co-Op Bank
therefore remains vulnerable to hostile takeover: it is a sign of the
times that this has not yet been attempted.
Co-Operative Group itself has been seriously damaged. The failure of
the Co-Op Bank torpedoed it below the waterline. It has had to sell
some of its most precious assets to plug the gaping hole and stop the
ship from sinking. We mourn the loss of the farms, the pharmacies,
the insurance services, and most recently Sunwin security services.
importantly, the Co-Operative Group has been forced to re-examine its
values and its governance. It must learn from the mistakes made both
by the Bank and by the Group.
Firstly, I question
whether a co-operative has any business owning a plc. It seems to be
a dilution of co-operative principles that within a co-operatively
owned group there can be one or more businesses whose customers do
not own or run the business.
Secondly, there is also the
question of management competence and integrity. Many have asked
whether Richardson was incompetent, negligent, corrupt or all three:
but those around him, who turned a blind eye to the real situation,
must surely be subject to the same judgement. Banking is a
specialised business requiring considerable skill and integrity. It
is fair to say that both skill and integrity appear to be in short
supply at senior levels across the entire banking industry. But in a
business that is supposed to embody co-operative values, surely the
skill and integrity of the management are of profound importance. The
primary job of the Board should be to ensure that management at the
Co-Op Bank is committed to co-operative values.
And finally, the Board itself must operate according to co-operative values - because in the end, this is what it is all about. If neither the management nor the Board demonstrate commitment to co-operative values, then can the Co-Operative Group really be said to be a co-operative at all?
A tale of two reviews - Coppola Comment
* In a mutual, there is no "equity" in the sense of at-risk shareholders' funds. Holders of "share accounts", which are building society savings accounts, are the shareholders of the mutual, though their accounts qualify for deposit insurance and are treated as debt in the mutual's books. Subordinated debt ranks junior to share accounts, but unsecured bonds currently rank senior. This means that in the event of a mutual failure, unless there is a very large cushion of subordinated debt, ordinary savers take losses ahead of institutional investors. Depositor bailout is therefore far more likely in a mutual failure than in a bank failure, and the seniority of unsecured bonds over savings accounts makes allowing a mutual to fail politically unacceptable. Many mutuals got into serious trouble in 2008-9, but not one was allowed to fail.