Stand By Your Bank

In my post on the "ethical" Co-Op, I argued that the Co-Op Group management is treating subordinated debt holders in the Co-Op Bank shabbily. Various people questioned this on the grounds that as the Co-Op Bank is a public limited company, the Co-Op Group's investment in its bank is limited to its stake and it is not obliged to provide additional capital: it could simply "walk away" and allow the bank to fail. This comment challenged me to explain why this is not the case:
The thing I still don't understand is why you think the Group can't walk away from the bank if it is a subsidiary Ltd company, as seems the case. Is there some legal entanglement beyond the usual corporate pyramidal structure? What is the mechanism through which you think the banks' liabilities can "move up" the limited liability barrier? This is not a question of ethics here, just basic corporate law. 
Let's imagine the group withdraws the current offer and stops contributing any new group cash into the Bank, and the regulator pulls the plug (stop allowing the insolvent bank to operate below regulatory limits). What happens? The bank obviously goes into administration under the new bank resolution regime. I would expect the group to be able to continue operating their remaining businesses as (almost) usual. They may face some extra losses from any inter-group claims (e.g. that discussion on whether the IT loss onto the Bank or onto the Group's IT subsidiary) but as such that might not be enough to make the group insolvent.
Is it that you think there's enough inter-group claims to take down the group, or something else? It may be worth a full post, I doubt I'm the only one mystified by the idea limited liability doesn't work as expected.
Indeed the Co-Op Group management themselves seem to think they could allow the bank to fail and still continue as a going concern. From the 2013 Co-Op Group Interim Results, p.15 (my emphasis):
The directors of the Society believe that it is likely that the recapitalisation plan will proceed, but have prepared sensitised forecasts for a period in excess of 12 months from the date of approval of this interim report which indicate that, should the recapitalisation plan not succeed, the Society and the Group (excluding the Bank) could still continue to operate within the terms of existing bank facilities. The Society’s directors do not believe, therefore, that the risks identified by the Bank’s Directors in relation to the ability of the Bank to continue as a going concern represent a material uncertainty to the ability of the Group (excluding the Bank) and Society to continue as a going concern.
So does the Co-Op Group have to stand by its bank?

When a bank is part of a financial conglomerate, the Prudential Regulatory Authority (PRA) has the power to direct its parent to recapitalise it. This power is intended for use in cases where a bank is owned by a holding company that is itself a financial services company and/or has other substantial interests in financial services. The Co-Op Group management is in effect assuming that because it is a retail group, the PRA's power of direction does not apply. Is this the case?

The definition of a "financial conglomerate" is set by the EU, which maintains a list of European financial institutions it considers to be financial conglomerates. The latest list can be found here. Listed at no. 57 is the Co-Operative Banking Group:



Now this is more than slightly confusing. The Co-Operative Banking Group Ltd and the Co-Op Group are not the same entity. Here's what the Co-Operative Banking Group Ltd has to say about itself: 
We are the financial services arm of The Co-operative Group and our businesses include The Co-operative Insurance, The Co-operative Bank, Britannia and the internet bank smile.
So the "financial conglomerate" as defined by the EU is not the Co-Op Group (a mutual) but a financial services holding company with limited liability which is 100% owned by the Co-Op Group. Does this mean that the PRA's  power of direction only applies to the holding company, not to the mutual that owns it? 

 From the PRA's statement of policy regarding power of direction, it seems that this may indeed be the case (my emphasis):
6. The definition of ‘qualifying parent undertaking’ includes
any UK-incorporated parent undertaking (or parent
undertaking with a place of business in the United Kingdom) in
an ownership chain which meets the definitions contained in
the Order, even if the undertaking is not itself the ultimate
parent undertaking. In general, the PRA would consider action
to be most effective when taken in relation to the ultimate
parent undertaking at the head of the ownership chain, as that
is usually where most of the power to direct and control the
group resides.
7. However, where the ultimate parent undertaking is not a
‘qualifying parent undertaking’
(for example if the group is
headed by a non-UK entity or a non-financial entity) then the
PRA will not have the power to direct that ultimate parent
undertaking. In such circumstances, the PRA may consider
that use of the power of direction over another qualifying
parent undertaking in the ownership chain is appropriate.
So the PRA would ideally like to direct the Co-Op Group to recapitalise the Co-Op Bank, but is unable to do so because the Co-Op Group is not defined by the EU as a financial conglomerate and is not a financial entity. The PRA can only direct the Co-Op Banking Group Ltd. But the Co-Op Banking Group Ltd is already divesting its insurance businesses: once these have been sold, not much will remain of it apart from the three brands that together make up the Co-Op Bank (they are separated out in the Banking Group's statement but are in fact one banking entity). If the Bank is allowed to fail, therefore, then the Co-Op Banking Group will fail with it. That is 92%  of the Co-Op Group's asset base, but currently contributes less than 10% of its income. It is therefore in theory possible for the Co-Op Group to cut its losses, allow the Co-Op Banking Group to go belly-up and continue in business as a pure retail group. And that is indeed what the Group is warning the bondholders that it may do. In response to Robert Peston's questioning of the proposed bondholder bail-in, the Group pointed out that the only alternative would involve much larger losses for bondholders:
And Co-op Group makes one further point. If the preference shareholders and bondholders don't like it, there is an alternative.
It is called resolution, in which the bank would be seized and rescued by the Bank of England, and the pref holders and bondholders would see the value of their investments reduced to a big fat zero.
In other words Co-op Group says the choice for bondholders and pref holders is between big losses and total losses.
Clearly, therefore, there is a huge hole in the definition of a "qualifying parent". I suppose, when the PRA was granted power of direction over parent entities, it was never envisaged that a supposedly ethical mutual would mismanage its bank so comprehensively that it entered regulatory insolvency, nor that the supposedly ethical mutual might then try to cut its losses and walk away from its bank, leaving little old ladies to lose their savings and the Government to pick up the pieces. The PRA's powers of direction were intended for large financial conglomerates like Lloyds, not for retail groups with a bit of banking attached. No-one has considered what the PRA's powers should be when a failing bank is owned by a retailer, and the legislation does not cover that situation. It desperately needs amending. Are we really going to allow the likes of Tesco, Sainsbury and (since the Northern Rock sale) Virgin to walk away from the banks they own, leaving bondholders and/or taxpayers to bear the costs of failure?

At present, the Co-Op Group is accepting some responsibility for recapitalising the Co-Op Bank, but wants to share that responsibility with the Co-Op Bank's subordinated debt holders. Viewed in the light of the Co-Op Group's apparent lack of liability, this looks generous. And it is also dangerous. Raising the funds required to make the Co-Op Group's contribution will increase its balance sheet leverage and therefore its business risk, especially as its non-financial asset base is so small. Not surprisingly, the Co-Op Group's own bondholders are not happy. According to Mark Kleinman at Sky
Lenders to the Co-Operative Group are demanding that its new management team slashes capital expenditure and provides greater protection for their loans in return for them supporting a sweeping financial restructuring.
So it seems the Co-Op Group's lenders are setting conditions for their support of the recapitalisation plan. Although they might be yet another group of the Bank's lenders, or the Banking Group's. The complexity - and opacity - of the Co-Op Group's organisational structure could confuse even an experienced journalist like Kleinman. And the approach taken by the Group to financial reporting doesn't in any way help to clarify matters. 

But the unhappiness of this group of bondholders is as nothing compared to the misery of the Co-Op Bank's subordinated debt holders, who stand to be stiffed, frankly. And they are angry. So angry that they have formed themselves into THREE groups, each taking a different approach to fighting against being bailed in:

  • Group 1, representing small investors, is running an orchestrated campaign to persuade anybody and everybody to excuse small investors from taking part in the bail-in ("Woodman, spare that tree!")
  • Group 2, made up of institutional investors, questions the entire rationale for the bail-in and accuses the Co-Op of rigging the figures to ensure the bondholders take more of the pain than they deserve;
  • Group 3, made up of hedge funds (which quite possibly only bought their subordinated debt holding when prices crashed after Moody's downgrade), wants to take over the Co-Op Bank. 

Predictably, the Co-Op Group is refusing even to talk to any of them until the share sale prospectus is issued in October. And the PRA, which probably realises it has very little leverage because the legislation does not give it the power to direct the Co-Op Group, is keeping its head well down. Though to its credit, in my view, it is still refusing to budge on the capital requirement, despite the attempts by both the Co-Op Group itself and Group 1 of the bondholders to persuade it to water it down.  

The Group 1 bondholders' attempt to persuade the PRA to use its power of direction to force the Co-Op Group to recapitalise its bank fully is I think doomed to failure for the reasons I have given above. And whether Group 2's accusations stick remains to be seen: there is certainly to my mind a serious question over £148m of sunk IT costs apparently written off but in fact allocated to the balance sheet of CFS Management Services Ltd., a sister company in the Co-Op Banking Group. But it would be far more difficult to prove that the vast provisions allocated against (mostly) ex-Britannia assets are unjustified. 

By far the most serious threat is actually from Group 3. Even if the 100% bail-in they propose is insufficient to plug the capital hole and/or some of the other subordinated debt holders refuse to take part, this group says it will top-up any shortfall itself - and it unquestionably has the means to do so. Group 3 is well-informed, well-organised and well-funded, and it means business. The Co-Op Group should take its threat seriously. 

If the Co-Op means to stand by its bank, it will have to engage with the bondholders - not only with the Bank's bondholders, but also with its own. Upsetting bondholders is not wise: investors can have long memories, and a company that comprehensively shafts not only its subsidiary's bondholders but its own is likely to be very unpopular in the marketplace for quite some time.  

Of course, if it becomes too painful to Stand By Your Bank, there is always D.I.V.O.R.C.E - as Robert Peston suggested when the Co-Op's difficulties first became apparent. Perhaps an independent Co-Op Bank in private ownership, and a Co-Op Group freed of the banking albatross round its neck, is the best solution to this unholy mess. 

Related links:

The "ethical" Co-Op - Coppola Comment
Under the radar - Coppola Comment
Co-Op Group Interim Results 2013
Policy statement: the power of direction over qualifying parent undertakings - Prudential Regulatory Authority
The Co-Op Bank: Dial B for Bondholder - FT Alphaville
Co-Op bondholders step up pressure for "plan B" on debt restructure - FT (paywall)
Co-Op Group lenders "close to new deal" - Mark Kleinman (Sky News)
Does Co-Op Group deserve to keep control of Co-Op Bank? - Robert Peston (BBC)
What does Moody's downgrade of Co-Op Bank mean? - Robert Peston (BBC)
The plausible executive and the ruined bank - Frances Coppola (Pieria)

Comments

  1. If only the Co-op could tap its seven million members, sorry owners, for more than one pound each...

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    Replies
    1. It can. Members can invest up to £20,000 each as withdrawable shares. And that's how the co-operative movement was built originally, on the foundation of its members' capital (the members of the Rochdale Pioneers each had to commit to contributing £5 in instalments - which would be the equivalent of a four figure sum today). There is a case for saying that the present crisis has its roots in The Co-operative Group's decision to discourage members from investing more than £1 and rely instead on external borrowing.

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  2. I'm interested in the difference between the bond holders of banks backed by a financial conglomerate and banks like the co-op not backed by anyone (do any other such banks exist?). Nothing you present here should be news to a bond holder who did due diligence - unless that is they were led to believe that the group would stand by the bank by some public statement in the good times, which no doubt one of the groups of bond holders will find if it exists. \
    \
    Perhaps the co-op wants to have it both ways - pay lower interest rates on their bonds as if the group was behind it but actually wiggle off the hook when the reckoning was due. But if the group never gave any indication it would automatically bail out bank bond holders then I'm not entirely sure why the bond holders need protection, they should have known that the bank goes bust no-one would bail them out.

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  3. Thank you for the post: interesting and thoughtful, as always. But I'm not clear about what you want the Co-op to do now. Earlier in the piece you write that it's generous and dangerous to support its bank, even to the limited extent that the Co-op Board proposes. But then you go on, if I've understood right, to argue that it nevertheless should do still more. Obviously the Co-op has got itself into a dreadful mess; and it's fair comment to say, in effect, I wouldn't start from here if I were you. But is your conclusion that the Co-op should either provide more support or less, and that its current stance is an unsustainable halway house?

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    Replies
    1. Elliot,

      yes, that is my conclusion. I don't think the Co-Op Group's attempt to distance itself from its bank's fate is acceptable, really. It must decide whether it supports its bank, in which case it should engage with the bank's creditors to obtain their buy-in to a mutually beneficial deal, or it does not, in which case it either accepts Group 3's offer or it places the bank in resolution. The present situation is not good for the Co-Op Bank's creditors or its customers, and is doing the Co-Op Group's reputation no favours. The management team may be operating in accordance with current law as it stands, but it is difficult to justify their behaviour on ethical grounds.

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  4. Thanks for the detective work, the service on this blog is amazing!

    The unholy mess is probably quickly going to turn into a full blow up, all these bondholders' groups seem to me to be rearranging the deck chairs on the Titanic. There's a lot of moving parts that can take the whole thing beyond salvation and it would be surprising none of them goes wrong.

    On the question as whether going forward non-financial groups should be banned from walking away from their financial subsidiaries, it's a tough one: while I agree you don't want Tesco to be able to walk away from Tesco Bank at the first difficulty, after having used their branding power in good times, do we really want a Tesco Bank gone big and bad to take down Tesco the grocery stores? It may be wiser to ban cross-ownership/branding, and require broad/public ownership of any sizeable bank. Virgin is another interesting case, as I have the impression it's done under a lightweight brand licensing model, where it's even harder to argue for "group" responsibility.

    Also glad the PRA is standing firm on the capital requirements, but they really can't afford to to otherwise: if they surrender here, for a relatively minor non-systemic bank, they will lose all credibility when it comes to be tough with the big boys.

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    Replies
    1. I actually think Virgin is a bigger problem than Tesco, because of its involvement in privatised utilities. The pressure for a Government bailout would be considerable if it got into trouble because of bad banking.

      I'm not sure how constructive it would be to ban retailers from owning banks. In-house banks are useful to staff and popular with customers. Might be better to extend the PRA's remit so that they can supervise and regulate non-financial entities that own banks.

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    2. My impression is that Virgin often doesn't control companies through ownership as such -- the group seems to often have only a minority stake -- but through brand licensing agreements, where they are a supplier to the subsidiary, who have to run the company in a "virgin way" in exchange of using the brand and presumably licensing fees. They are suppliers: the individual companies could notionally buy branding services from someone else. If I'm correct here, I can't see how you could have full responsibility. Why pick a particular minority shareholder or supplier?

      In the case of Virgin Money I couldn't find quickly what their share is exactly but some other guy has 45% and there's at least one other minority shareholder, and they want to float it, so I can see them ending with a minority share even if they may be just above 50% now.

      This eliminates contagion but the taxpayer is on their own in case of failure.

      On in-house banks of retailers I'm not sure the systemic risk is worth the benefits to staff or customers, compared to them having an arms length deal with a partner bank providing banking services linked with the store card etc. This limits the profits they can make from banking, but we do want that, grocers should keep to their trade.

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    3. Hmm. Maybe I should have a closer look at Beardy Bank, then. I don't like the sound of that. Opaque and complicated governance with no clear responsibility potentially leaves the Government on the hook, as you say. We really need to have some rules on what are and are not suitable governance structures for banks.

      Most in-house banks seem to start off as arms-length deals but the retailers then take them over. I'm not clear why but I would guess it is because they are lucrative!

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  5. If these branded banks are not financially backed by their parent company could it not be argued that that is at least a little diseptive and misleading from the point of view of the FSA and Trading standards. What is the aim of the Branding in the case of attracting deposits and what is a the recipient supposed to make of a cheque with Tesco, Sainsburies or Virgin printed on it. The whole point of branding is to benefit from assosiation, and when it comes to confidence in Banking that is rather important.

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  6. The situation with the co-op group is not quite as clear as the article suggests.
    The powers of the PRA to direct the co-op group to bail out the bank come from the financial services act 2012 and section 192B gives the treasury the ability to alter the definition of a "qualifying parent undertaking" in virtually anyway it feels necessary including removing any reference to it needing to be a financial institution
    In the event of resolution things are even clearer since the Banking Act 2009 allows the parent holding company to be taken into temporary public ownership if this is felt necessary and the only conditions are that it owns a failing financial institution and the holding company is an undertaking incorporated in, or formed under the law of any part of, the United Kingdom.

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    Replies
    1. Dave,

      Apparently it's even less clear than that. The FSA thought that the Co-Op Group might qualify as a "mixed financial holding company", which would give the PRA powers of direction, but agreed to a 3-year waiver of Co-Op Group being officially designated a "mixed financial holding company", apparently in order to avoid complicating the Verde deal. That waiver remains in force even though the FSA has now been replaced. Something stinks round here!

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  7. In reality the Co-op group seems to be behaving rather like Ryanair. There is a generally accepted way of doing business where transactions and responsibilities are not restricted to the legal minimum, and then somebody comes along and deliberately tries to reduce their liabilities to that legal minimum.
    The end result is usually disadvantageous to everybody but the perpetrator and eventually results in new legislation.

    ReplyDelete

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