The plausible executive and the ruined bank
The Co-Op Bank's former CEO, Neville Richardson, gave evidence to the Treasury Select Committee on the circumstances surrounding the failure of the Verde deal. In the course of that evidence, he made the following claims about the Co-Op Bank's finances:
- the Britannia building society, which the Co-Op took over in 2009 (and of which he was previously the CEO) was not the primary source of the toxic assets that have blown a large hole in the Co-Op Bank's capital;
- when he left the Co-Op Bank in mid-2011 it was profitable, well-managed and there were no signs of credit problems in its asset base.
I admit I found this hard to swallow. But Richardson made these claims on the basis of figures derived from the Co-Op Bank's report and accounts which he submitted in his written evidence to the Treasury Select Commitee. And his presentation was straightforward and plausible. So I thought I would have a look myself and see if there really was any justification for his claims.
The Co-Op Bank's eye-watering loss in the 2013 interim results was made up of the following items:
£10 m Provisions for customer claims regarding interest rate hedges mis-selling
£25 m Provisions for customer claims regarding PPI mis-selling
£26 m Provisions for customer claims regarding card & identity theft insurance mis-selling
£10m Costs incurred from failed bid for Lloyds branches (Verde)
£14.7m Costs incurred on a programme of investment and integration
£9.9m Impairment of plant, property and equipment
£148.4m Intangible asset impairment costs regarding development of new IT systems
Impairment of loans & advances to clients
£24.8m Retail banking
£140m Corporate and business banking
£ 36.2m Other non-core
That gives totals as follows:
£61m Mis-selling provisions
£34.6m Costs and impairments arising from failed Verde bid
£148.4m IT system replacment costs (intangible asset impairment)
£165.5m Impairments in Core business
£330.5m Impairments in Non-Core business.
The commentary defines Non-Core as follows:
"Non-core business lines predominantly include the Corporate Banking lending business, Optimum (the closed book of intermediary and acquired loan book assets) and Illius (the residential property company) businesses which originated from the non-member Britannia business prior to merger."
So it seems the ex-Britannia assets that are supposed to have caused all the problems are in the Non-Core division. I doubt if the separation is anywhere near as clean as that in reality, since the Directors suggest that more work is needed to confirm exactly what should be in Non-Core, and there is a very odd split of commercial property between core and non-core. However, let's assume for the moment that the split is reasonably clean. Where does that leave us with respect to the assignment of losses between Co-Op and Britannia?
According to those figures, Richardson is correct. The total impairments arising from Non-Core, which we assume are mostly ex-Britannia assets, amount to £330.5m. But the total of losses and impairments (unadjusted) is £740m. Therefore the majority of the loss arises from Core business impairments and significant items, a large part of which stem from the failure of the Verde deal - which Richardson had opposed. It seems he has a point.
But not much of one, really. His first claim is correct, but his second is far more dodgy. Richardson was CEO of Co-Op Bank until July 2011. The first signs of trouble at t'bank emerged in the 2012 interim report, when a large number of commercial property loans were downgraded to "weak" for credit risk purposes, and there was an increase in impairments in the Corporate and Business Banking division. That was less than a year after Richardson's departure.
The Co-Op Bank's commentary to the 2012 interim report blames the increase in impairments on the difficult economic climate, and this might indeed account for some of it. But not all of it. In the 2011 full year report, an astonishing £3,570.5m out of a total loan portfolio of £11,053.7m were described as "unrated" for credit risk - almost a third of the entire portfolio. By the time of the 2012 full year report the number of "unrated" loans had declined to £2,587.1m out of a total portfolio of £11,402m, slightly less than a quarter. But loans in default had increased from £921.3m to £1,994.7m - hence the huge increase in impairments. 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, or had assessed far too optimistically. The Co-Op under Richardson was not in control of its loan book.
Richardson argues that the increase in impairments in the 2013 interim results was due to a considerable tightening in credit risk assessment criteria. This is true. But it is hard not to conclude that in arguing that those impairments wouldn't exist if credit risk assessment criteria had not been tightened, Richardson is indulging in special pleading. Poor credit risk management was a key driver of the financial crisis. The fact that banks everywhere have been tightening credit risk assessment criteria is a response to that. The Co-Op is late to the party, but there is no reason whatsoever to exclude it. If the new management have tightened criteria, it is because they needed to do so - in which case the criteria in operation under Richardson's governance were inadequate.
Richardson claims that the quality of the Co-Op Bank's loan portfolio deteriorated during 2011 and 2012 because of management overstretch arising from strategic initiatives instigated by the Co-Op Group:
"In the circumstances referred to above it is little surprise to me that control over loan management deteriorated significantly in 2011 and 2012."
This is not remotely believable. The risks that led to the impairments recognised in 2012 and 2013 were already present in 2011. There is no evidence whatsoever that control over loan management deteriorated in 2011 and 2012: if anything, the evidence is to the contrary, since the impairments identified in 2012 and 2013 were a result of re-assessment of existing loans. If there was inadequate loan management, it was in the years prior to 2012 - in other words, during Richardson's time as CEO.
Richardson argues that the Co-Op would not be in trouble if the regulators had not changed the capital requirements. I can't see how this can be true. Retail lending was by far the biggest part of the Co-Op Bank's activities, but it seems to have had little real idea of its credit risks: a substantial proportion of its loans were already weak and/or defaulted but not recognised as such, recognised impairments were too low relative to defaulted loans and a third of its loan book was not even rated for credit risk. Even without the subsequent tightening of credit standards, if the true state of its loan book had been disclosed in 2011 it would have failed to meet regulatory capital requirements at that time.
However, even if it were correct that the Co-Op Bank's troubles were entirely due to increased regulatory capital requirements, it would not be an argument for the Co-Op Bank to be allowed to operate with capital ratios far below the minimum now required by regulators. And Richardson's claim that the increased capital requirements were recent is apparently untrue anyway. Andrew Bailey, head of the Bank of England's Prudential Regulatory Authority - evidently considerably peeved by Richardson's accusation - said they had observed in 2011 that the Co-Op Bank would probably need more capital. And that was before the scale of the weak and defaulted loans and associated impairments came to light.
Richardson argues that commercial property was only a small part of the Britannia's balance sheet. But the Co-Op also inherited a large residential mortgage book from the Britannia. Richardson suggested that there was "not much" subprime inherited from Britannia, but this is demonstrably untrue. Over 40% of the loans in the Optimum residential mortgage book inherited from Britannia are 90% LTV or higher - which is subprime lending - and of those, more than half are in negative equity:
The balances are huge for a bank of that size. By any standards, the Co-Op Bank has substantial sub-prime exposure, nearly all of it inherited from the Britannia. It is worth remembering that Richardson was CEO of Britannia before becoming CEO of the Co-Op Bank: it is not surprising that he is trying to claim that Britannia was in good shape before the merger, but the financial evidence does not support his case. House prices simply have not fallen enough to create the extensive subprime exposure that currently exists in the Optimum book.
The Co-Op Bank split its loan book into Core and Non-core in 2012, and the Optimum book now sits in Non-Core along with a substantial amount of corporate lending and commercial property lending. An astonishing 59.2% of the loans in Non-Core are impaired under the new tighter credit standards. But it has not done the job of splitting Core and Non-Core very well. As of 30 June 2013, 11.8% of core loans are also impaired, mostly in commercial property lending.
The evidence suggests that the Co-Op was already a seriously damaged bank by the time of Richardson's departure. If he wasn't aware of this, then his competence as CEO must be called into question. If he was, then it is not his competence that is in question, it is his integrity. Either is sufficient to justify banning him from working in financial services again.
The Co-Op Bank currently does not have sufficient regulatory capital to continue trading. It is, in short, bust. Recognition of a £709m loss in the 2013 interim results reduced the Co-Op Bank's Core Tier 1 (CT1) capital ratio to 4.9%, and its Basel III Common Equity Tier 1 (CET1) ratio to 3.2%. This is regulatory insolvency: the Co-Op Bank's capital ratios as shown in their Pillar 3 disclosure do not meet even Basel II requirements, let alone Basel III, and are well below the minimum requirements set by the PRA. Regulatory insolvency is not the same as legal insolvency: the Co-Op Bank is not breaking the law by continuing to trade. But it can only continue as long as the regulators are prepared to allow it to do so, and that may not be for very long - after all, as we know from the financial crisis, a bank that has insufficient regulatory capital is an unsafe bank.
This paragraph from KPMG's "independent review" of the Bank's accounts summarises the situation nicely (my emphasis):
Emphasis of matter – Going concern
In forming our conclusion on the condensed set of financial statements, which
is not modified, we have considered the adequacy of the disclosures made in
part 3 of the Basis of Preparation section of the condensed set of financial
statements concerning the Bank’s ability to continue as a going concern; in that
section the directors set out the risks associated with the successful execution
of the recapitalisation plan. These conditions indicate the existence of a
material uncertainty which may cast significant doubt on the Bank’s ability to
continue as a going concern. These condensed financial statements do not
include the adjustments that would result if the Bank was unable to continue as
a going concern.
In other words, if the required capital cannot be raised, the bank will have to be wound up. Bondholders should take note: the Exchange Deal is unfair to them, but the alternative could be worse. They should consider whether the Co-Op Bank is worth more to them alive or dead.
Co-Op Bank financial statements:
The "ethical" Co-Op - Coppola Comment
Under the radar - Coppola Comment