The Co-Op story: a tale of two banks

The Co-Op story: a tale of two banks

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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.

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Whereas the 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 be.

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 business model.

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

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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 mutuals.

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 £1.9bn.

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:

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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 of:

  • deposits

  • 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. Main article image

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.

Prior to the financial crisis, banks and building societies had got into the habit of running with very little equity. The Britannia and the Co-Op were no exception. Since then, regulators have tightened capital requirements considerably. Capital requirements were tightened at least twice during the period that the Co-Op Bank's difficulties were being discovered. This is why there were complaints about regulators moving the goalposts. It is fair to say that had regulators not tightened the rules, the Co-Op would not have had to raise so much additional capital. But do we really want banks running with paper-thin wedges of capital? Why should a bank owned by a co-operative but not run as one be excused from these tighter capital requirements that are designed to protect customers?

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.

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Nevertheless, the 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.

And the 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.

But more 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?

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Related reading:

A tale of two reviews - Coppola Comment

The plausible executive and the ruined bank

In praise of hedge funds

* 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. 


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