Friday, 14 June 2013

Under the radar

This is the interesting story of how the Co-Op Bank got itself into a terrible mess without anyone noticing.

The Co-Op Bank was originally created by the Co-Operative Group, a mutually-owned retailer, primarily but not exclusively to serve the needs of its members. It painstakingly created a brand image around ethical banking and customer service, and aimed to occupy a small unique niche in the UK's high street retail banking landscape. To describe it as a "mutual" in the same way as a building society is misleading. It is not. It is a wholly-owned subsidiary of a mutual, and it is a bank. That is in theory a significant difference.

But in the run-up to the financial crisis, the differences between banks and building societies had become increasingly blurred. Many building societies had converted to banks - floating themselves on the financial markets - and in turn been swallowed up by larger banks. And many of the remaining building societies were acting much more like banks, borrowing large amounts of wholesale funds and doing commercial lending and commercial real estate lending in addition to their traditional residential mortgage lending. Even their mortgage lending was becoming riskier as they lent to less creditworthy borrowers at ever-higher loan-to-value percentages. Short of capital because of their mutual status - and a widespread belief at the time that capital wasn't important anyway - some of them became as highly-leveraged as banks.

In the fallout from the Lehman failure in 2008, followed by the nationalisation of RBS and Lloyds/HBOS, these highly-leveraged building societies got into serious difficulty.  One (Dunfermline Building Society) failed and was nationalised. Another (Kent Reliance) was bought by the private equity firm J.C. Flowers. Some were forcibly merged with others - the Nationwide, the UK's largest building society and now its fifth largest lender, swallowed three smaller building societies. And one - the Britannia building society - was bought by the much smaller Co-Op Bank in a deal reminiscent of the RBS takeover of NatWest.

At the time there were no public indications that the Britannia was in trouble. Indeed some people questioned the merger because it didn't seem a particularly good deal for the Britannia's members and staff. Whether, behind the scenes, government did know that the Britannia was in trouble and forced through a merger as part of its strategy of avoiding building society sector meltdown, we may never know. What is clear is that the Co-Op's CEO, Peter Marks, and the Britannia's CEO Neville Richardson, were very happy with the deal. The Co-Op Bank's CEO lost his job in the merger and was replaced with Richardson, who ran the enlarged Co-Op Bank for the next two years. He eventually left in a management shakeout in 2011.

And it was in 2011 that the true state of the Britannia's finances started to emerge. In the 2011 accounts, the Co-Op put £1.45bn of the loans it had inherited from the Britannia on "watchlist". This meant that they were not actually in default but were considered likely to default at some time in the future. And sure enough, in 2012 the Co-Op was forced to account for £0.5bn of new impairments on its ex-Britannia loan portfolio as corporate loan defaults doubled. This, along with provisions for claims on mis-sold PPI insurance, wiped out the Co-Op Bank's entire profits.

In November 2012 the Bank of England's Financial Policy Committee - flexing its newly-acquired regulatory muscle - announced that a number of UK banks were short of capital. And in February 2013 it emerged that the Co-Op bank was one of them. At that time the extent of the capital shortfall was unclear but it was thought to be of the order of £1bn. Since then the estimates have risen and the hole is now around £1.8bn. Because of the mutual status of the Co-Op Bank's parent, plugging this hole was never going to be easy. Mutuals are owned by their members, not by external shareholders, so raising new capital via the financial markets is nigh on impossible to do (though subordinated debt - convertible to equity - can be raised). Consequently, mutuals usually rely on organic growth, cost-cutting and/or divestments to improve their capital position.

Despite concerns about the Co-Op Bank's weak balance sheet, negotiations with Lloyds Banking Group for acquisition of the Verde branches continued. Once again, it seemed, the Co-Op Bank was intent on swallowing something much larger. Acquiring the Verde branches would have trebled its balance sheet size and placed it among the UK's largest lenders. The Verde branches were better capitalised than the Co-Op Bank and came with their own version of the LBG IT platform which the Co-Op Bank would have to adopt. Because of this the Co-Op Bank scrapped its own IT upgrade programme, writing off £1.5bn of sunk cost.

In April 2013, to everyone's consternation, the Co-Op Group decided to pull out of the Verde deal. The Co-Op's statement was terse:
The Co-operative Group announces that it has withdrawn from the process currently being run by Lloyds Banking Group for the disposal of branch assets (“Verde”) after The Co-operative Group and The Co-operative Bank plc Boards decided that it was not in the best interests of the Group’s members to proceed further at this time. This decision reflects the impact of the current economic environment, the worsened outlook for economic growth and the increasing regulatory requirements on the financial services sector in general.
The Co-Op's attempt to blame the failure of the deal on the weak economy and unhelpful regulatory stance impressed no-one. Most commentary at the time was along the lines of "wonder what's really behind this"? And the real reason quickly became apparent. On 10th May 2013 the ratings agency Moody's abruptly downgraded the Co-Op Bank's credit rating to junk, citing poor capitalisation and anticipated further losses on its ex-Britannia loan portfolio against which it had insufficient loan provisions.

The departure of the Co-Op Bank's CEO, Barry Tootell, immediately after the downgrade was no surprise to anyone. But it left the Co-Op Bank leaderless at a time when the Co-Op Group was also about to undergo a change of leadership, with Euan Sutherland from Kingfisher Group taking over from Peter Marks.

The Co-Op's difficulty raising capital was the subject of considerable debate. In its statement, Moody's observed that the Co-Op Group's subordinated debt holders might have to take losses. Predictably, the value of those bonds promptly crashed. But Moody's suggestion that the Co-Op Bank might get taxpayer support was promptly squashed by both the Co-Op Group and by the government. Divestment of parts of the business was the focus of most debate. Many people pointed out that the Group was unlikely to raise the needed capital by selling its insurance businesses and would have to look at other divestments. Robert Peston suggested that the Group might even consider selling its bank, because otherwise it might have to divest key parts of its retail business. Frankly this was ridiculous. The present climate is hardly a good one for selling a seriously damaged bank stuffed full of toxic loans: the Co-Op Group would have had to retain a considerable proportion of those loans in order to make the bank remotely attractive to a buyer. And the Co-Op Bank's unusual position in the UK's market made a sale problematic: customers were not likely to be happy with a private equity takeover like Kent Reliance, selling to a high street bank would probably fall foul of competition rules, and the larger mutuals were already suffering from a bad case of indigestion after the last round of takeovers and mergers.

Fortunately the new Co-Op Group's CEO moved swiftly to squash any ideas of a sale, appointing Niall Booker as CEO of the Bank and deputy CEO of the Group. Booker's entire career had been spent in retail and corporate banking, and his most recent job had been restructuring HSBC's North American division after the subprime crisis. Clearly he had experience of rescuing damaged banks. And this was followed up with the appointment of Richard Pym as part-time Chairman of Co-Op Bank in addition to his role as chairman of UKAR, the holding company that manages the run-down of the residual Bradford & Bingley and Northern Rock bad assets. To me these appointments could not make it clearer that the Co-Op intends to keep its bank. And this view is supported by Co-Op statements to date.

So where does this leave us? And how is it that the Co-Op Bank's dreadful situation slipped under the radar? I have a number of thoughts on this.
  • In the aftermath of the financial crisis there was a prevalent belief that the crisis was caused by, firstly, investment banks and secondly, big banks. Small banks and specialist lenders were widely  believed, both by customers and by people who should have known better, to be "safe". And the Government fostered this illusion, perhaps because admitting that the UK's entire high street banking sector was dangerously leveraged and could fail at any moment would have spooked customers and caused the very disaster they feared. The Co-Op was a small bank and the Britannia a building society. Both, therefore, fitted into the prevailing model that big banks = bad and small banks (and building societies) = good. We now know that this model is flawed: all banks, big and small, including those (like building societies) that aren't called banks but do bank-like things, were damaged in the financial crisis. Arguably, the public's belief that building societies were safer than banks saved that sector from total collapse, because many people moved their money from banks to building societies at that time.
  • The Co-Op Bank's "ethical" image created a mistaken belief among its customer base that it would act responsibly. But ethical banking and responsible banking are not the same thing. I was less than impressed by the Co-Op Group's 2012 review, where they presented the operating profit as the headline result for Co-Op Bank and downplayed the fact that the bank had made a loss of £674m due to impairments and provisioning. If RBS - a much bigger bank and one already known to be seriously damaged - had done the same with its 2012 accounts there would have been hell to pay. RBS correctly reported its loss of £5bn as its headline figure, and it took some digging through the accounts to discover a pretty healthy operating profit that had been wiped out by fair value revaluation of its own debt, provisioning against mis-selling claims, and restructuring costs. In contrast, the Co-Op Group headlined the bank's operating profit with - in my opinion - the clear intention of misleading members and investors into believing that it was in better shape than it actually was. This to me is not ethical behaviour. I hope that the new board adopts a more open, honest and transparent approach to financial reporting in future.
  • Moody's deserves censure for its failure to downgrade the Co-Op Bank earlier. A 6-notch downgrade at one go smacks of being asleep at the wheel. No institution falls apart as dramatically as that without warning: there should have been an interim downgrade in 2012 after production of the 2011 accounts, in which the watchlist loans were declared. Moody's did look at the Co-Op Bank in 2012 as part of its general review of UK banks at that time - but bizarrely it actually UPGRADED the Co-Op Bank's standalone rating. I can only conclude it did not examine the 2011 accounts properly.
  • There are to my mind serious questions over the conduct of both Peter Marks and Neville Richardson. We now know that the Britannia had a huge toxic loan portfolio that would have caused it to fail had the Co-Op merger not gone ahead. But that doesn't appear to have been disclosed at the time - or if it was, Peter Marks must have decided to go ahead with the merger anyway. There are questions that need to be answered about the nature and extent of due diligence prior to the merger going ahead. And why did the Co-Op make no attempt to integrate its Britannia acquisition until after Richardson's departure? In fact it didn't even seem to know what was in the loan book. Call me cynical, but I can't help wondering if Richardson knew perfectly well that the Britannia loan portfolio was a disaster and concealed it from the Co-Op Group management. If that is true, then his behaviour is worse: Marks' megalomania made him foolish, but Richardson's behaviour is verging on criminal. I would like to see a proper inquiry into the circumstances of the Britannia merger and Richardson's subsequent tenure as Co-Op CEO. Unfortunately, as it seems the Co-Op Bank will not be bailed out by taxpayers, I am unlikely to get my wish.
  • There are also questions about the conduct of regulators, politicians and Lloyds Banking Group itself in relation to the Verde deal. The true state of the Co-Op Bank's finances was a matter of public record. But the Chancellor was an ardent supporter of the deal, hailing the prospect of an enlarged Co-Op Bank as a challenge to the dominance of the big banks on the high street. And the FSA, though not a supporter, did not act to prevent it. Lloyds, too, appeared totally bemused by the Co-Op's decision to pull out. It does not seem as if much in the way of due diligence - or even basic financial analysis - was going on anywhere. The Treasury Select Committee has now decided to investigate the circumstances of the failure of the Verde deal, a decision I welcome.  

It is all too easy for customers, regulators and politicians to be lulled into a false sense of security by bank management that is determined to hide the real state of affairs. The Co-Op Bank to my mind has systematically deceived everybody. It is unfortunate that a bank which commands such loyalty among its customer base should now have such a tarnished image. I hope that the new team cleans up its act. Because if it does not, it does not deserve the support of its customers. And the UK's banking sector would be the poorer for the loss of such a distinctive brand.

But there is also a wider issue here. This is far from being the first time that a bank has been brought to its knees by acquisitions, smiled upon by regulators and encouraged by politicians, that have turned out to be toxic. Indeed the Co-Op is only the latest in a very sorry list that includes LBG's acquisition of HBOS, RBS's acquisition of ABN AMRO, Barclays' acquisition of part of Lehman and a whole swathe of unwise and toxic mergers among banks in other countries such as Spain. To my mind it is not acceptable that distressed financial firms are rescued at politicians' behest by other financial firms while regulators turn a blind eye and laws are changed or waived to enable deals to go ahead - but that is what happened both in the headline-grabbing bank meltdown of 2008 and in the subsequent building society collapse of 2009. And as RBS, LBG and now the Co-Op show us, we still end up paying. They may have been prevented from collapsing, but they aren't able to support the economy. RBS and LBG have been restricting new lending, particularly to businesses, for the last five years. And the Co-Op Bank has now closed its doors to new business customers. The damage done by the Britannia merger will reverberate for years to come as both the Co-Op Bank and its parent are forced to restructure and shrink in order to close the bank's capital hole. We really have to find a way of dealing with systemic failures that doesn't involve wrecking healthy banks.

UPDATE - 17th June 2013
It has now been announced that the Co-Op bank will bail in its subordinated debt holders in order to raise part of its capital requirement, now confirmed by the Prudential Regulation Authority as £1.5bn. This will mean that it will no longer be a wholly-owned subsidiary of a mutual. It does not, as some people have suggested, in any way change the mutual status of the Co-Op Group itself, and as the proportion of external shareholders will be small, the Co-Op Group will continue to have a controlling interest. It does mean that holders of the PIBS inherited from the Britannia and the Co-Ops own preference shares, some of whom are very small investors, will take big losses and - perhaps even more importantly for some of them - will lose certainty of income, since the Co-Op Bank is unlikely to issue much in the way of dividends to shareholders until its balance sheet is in better shape and both PIBS and pref shares provide guaranteed interest income.

The remainder of the capital requirement will be met by divestments, primarily of the insurance lines, and by an injection of capital from Co-Op Group itself if necessary. There are no proposals to bail in depositors Cyprus-style.

The Co-Op Bank has already been split internally into good bank and bad bank, like the other damaged banks RBS and Lloyds, and the bad bank will be progressively wound down over time. However, this does mean that the Co-Op Bank will continue to suffer losses on its loan book for some time to come. It is unlikely therefore to be able to do much in the way of risky lending (such as to SMEs) for quite a while, which is unfortunately not helpful to the economy.

The proposed bail-in of bondholders is likely to trigger a further downgrade of the Co-Op Bank's credit rating, since it amounts to a partial default.

Related links:

Moody's statement on Co-Op Bank downgrade
Co-Op woes embarrass regulators and Treasury - Robert Peston
What does Moody's downgrade of Co-Op Bank mean? - Robert Peston
Treasury Committee to inquire into "Project Verde" - HM Government
Co-Op Group 2012 Annual Review
Co-Op Bank 2012 Financial Statements
Co-Op capital hole threatens Lloyds deal - FT (paywall)
Feelings not mutual - Big Issue In The North

Co-Op Bank's stock market future - Peston


  1. There is little more to the Kent Reliance story which could make it an interesting model. The company has an ownership structure which allows it to retain a membership interest. It is a kind of hybrid between a mutual and a privately owned bank, at least that is how I understand it. I'm not sure it is a model the Co-Op would want to follow.

    1. Flowers is gradually upping its stake via acquisition/convertible shares (Prestige and Interbay). Not long now before it has a majority interest and boots out the old mutual KRBS "members", I reckon. (The reinvented KRBS got 60.3% of the ordinary share capital in the new venture when the takeover took place but it's just 54.28% now).

      Since the Co-op Group is the single shareholder in Co-op Bank, I'm not sure why it doesn't take the whole hit. Lloyds and RBS shareholders suffered enough in the collapse of their investments? Why isn't Co-op Group, the shareholder, stumping up more/the lot rather than the junior bondholders? Or would that mean floating the whole thing? Andrew Regan, where are you now?

  2. You're right about the political narrative Frances, big/investment bad, small/retail good. It is an easier political sell because of the public's view of the city and pay in investment banking.

    I know you don't agree. But I think the only way that you are going to reduce systematic risk is by bringing down leverage and increasing equity. The systematic risk from equity being destroyed is so much lower than creditor loss.

    It also highlights the uselessness of regulations, and although it is popular to cry for more regulation as if there is a continuum/dial that can be set, it clearly doesn't work.

    The entities that failed and caused the most damage were the most regulated (Fannie, Freddie, AIG) whereas hedgefunds fail all the time and cause very little systemic risk. A large part of that is due to the fact that creditors for hedgefunds do not have false comfort that they are regulated and therefore safe.

    1. I don't actually disagree about need for more equity. My argument in the blog to which I think you are referring is that when unsecured and uninsured debt is convertible to equity under a bank resolution directive (even if there is nothing in the debt agreement that makes it convertible), then there is effectively far more Tier2 equity anyway. I also argued that as both equity and debt tend to be owned by ordinary people through their investment funds, the idea that by increasing equity we can protect ordinary people from losses is simply wrong.

    2. all profit and losses ultimately fall on households.

      m&m would say that the aggregate cost of capital isn't changed, but in reality increasing equity would increase the cost of capital. it would make some banking activity uneconomic, on the positive side though, it would reduce exposure to low probability events, which by their nature have the most uncertainty and systematic risk.

      the reality is that losing 10% of your stock portfolio is not the same experience as losing 10% of your bond portfolio.

    3. I have serious reservations about M&M anyway, because I am not convinced that balance sheet risk is always correctly priced - there are huge information asymmetries which can mean that equity is under- or over-priced relative to debt. Actually the Co-Op is a fine example of this. But the presence of the tax shield completely undermines M&M. Debt is ALWAYS cheaper than equity because interest cost is tax-deductible whereas dividends are not.

      I doubt if the ordinary "man in the street" can tell the difference between stocks and bonds. He will therefore be equally concerned about losing either.

    4. even in theory most models assume that credit spreads increase with leverage so min wacc point is not at 100% debt finance. anyway the main point is that by increasing the cost of capital you change the nature of risks slightly. low probability risks are the most dangerous because they require leverage to exploit and because the losses are so concentrated in time and are so systemic.

      i disagree that the ordinary 'man on the street' would be indifferent to losing 10% on bonds or 10% on equities. if they have absolutely no knowledge of the securities they are going to buy funds marketed on their risk and return, or have taken some form of advice / structure that takes this into account.

      there is a good reason that losing 10% on a bond is a lot worse than losing 10% on an equity.

    5. It's amazing how people can fail to understand that higher returns also mean higher risk. Therefore I disagree with you that ordinary people are more accepting of losses on equity than bonds. Yes, they will have been told about the risks - but when it actually happens and they lose part of their pension, they scream just as loudly if their pension was invested in equities as if it was invested in bonds.

    6. that is the thing though, people don't associate that extra 50bps they earn by chasing yield as taking risk unfortunately. i know a couple that put money in icesave and talked about it as a prudent decision because they were maximizing the interest they received, as i presume many councils did.

      investors will be unhappy when a mutual fund or equity investment loses 10% but it is well within the bound of expected scenarios. it isn't shocking or something that they are going to scream about, whereas dropping 10% on something that you incorrectly assumed was safe is much worse.

      it isn't being more accepting of losses per se, part of it quite rightly is looking at the loss in proportion to the expected upside. losing 10% on a bond is a lot worse if your upside was only 4%, whereas losing 10% on an equity where your upside was 15% is nowhere near as bad.

  3. “We really have to find a way of dealing with systemic failures that doesn't involve wrecking healthy banks.” There is a very easy way of preventing sudden bank collapses (assuming that equates to what Frances calls “systemic failures”).

    First, where depositors want £X back for every £X they deposit, their money should be put only into ultra-safe loans/investments, e.g. government debt or mortgages where the house owner has an equity stake of a good 30% or so. Bank failure cannot stem from that activity.

    Second, if depositors want their money put into something riskier, they should be forced to carry the full cost in the case of the risks going bad. If a depositor wants the upside profit, why should the taxpayer carry the downside loss? That way the bank as such cannot fail, although it can certainly shrink to nothing over a period of time. But that shrinkage doesn’t matter: it’s the SUDDEN FAILURES that cause the big problems.

  4. For a little data-driven discussion on why banks tend to fail, it would be useful to look here. There's a discussion on credit co-operatives (Section D, page 15, and noting your point that the Co-op was a bank) that essentially finds that non-traditional activities made them more unstable.

    - @lolgreece

  5. "One (Dunfermline Building Society) failed and was nationalised." Are you sure: I thought that Nationwide hoovered it up?

    1. No, Dunfermline was nationalised then broken up. Nationwide bought the good assets and brands (including Cheshire and Derbyshire). The bad assets were originally taken on by the Bank of England then transferred to the Treasury.

  6. You're right about the political narrative Frances