18 June 2013

What is Going on at the Co-operative Bank?

A longer-than-usual guest blog by Peter Pannier and begins a process of analysis of the troubles at the Co-operative Bank and their implications for UK mutual and/or financial institutions (questions and comments welcome via @peterpannier on twitter)

The idea that the Co-operative Bank and the 47 remaining building societies represent a positive alternative to mainstream banking been most enthusiastically pushed recently by the Move Your Money organisation as well as by anti-capitalist activists, Greens and supporters of the alternative economy. So where are we following the furore surrounding the Bank's 'rescue plan'?
Yesterday (17 June 2013), the Co-operative bank announced its plans to meet the capital requirements of £1.5bn (non-specialists might prefer the Guardian summary). This follows a decision earlier in the year to abandon a bid to take over 631 branches from Lloyds Banking Group, dramatic downgrades by Fitch, S&P and Moodys, and a changing of the guard at the boards of both the Bank and the wider Co-operative Group.
Some people have started asking some pretty good questions about what went wrong at the Co-op: Ruth Sutherland comes up with a dozen and more recently Patrick Collinson put forward another eight.

The problems can be traced back to the takeover (announced in October 2008 and completed in August) of the Britannia Building Society, where the issues were:
  • A high volume of (mispriced) commercial property loans, made at the top of the market. With empty shops and low consumer demand, this portfolio seems unlikely to regain any value in the near future.
  • A high volume of (mispriced) risky mortgage lending, also made at the top of the market. Again, arrears and repossessions are rising, real wages are falling (meaning making mortgage payments is getting harder), while we still have record low interest rates.
  • The need to raise capital ratios because of higher capital requirements instituted since the financial crisis, and the difficulty of doing this through retained profits.
  • An inability to raise capital by issuing shares. Many people have suggested this is because of the banks mutual status, but this is wrong. The Co-operative Bank is a plc, hence its ability to convert bonds into listed shares (see this diagram of the ownership structure). The reason the Co-operative Group could/cannot raise capital through issuing equity is two-fold. First, despite the fact that its ownership model does not prohibit it, it has been trading on the idea of being a ‘mutual’ ‘alternative’, and shareholder equity doesn’t fit with this PR image. Secondly, if it tried to issue equity while in crisis it would likely experience the same problem as RBS – no-one wants to buy shares in your bank when it looks like they are going to be throwing their money away. Hence why it has converted bonds (which don’t count toward capital) into shares (which do) instead.
Before the merger with the Co-operative Bank, Britannia was the second largest Building Society in the country. Contrary to perceptions of building societies being safe, traditional, and guided by ethics and principles rather than profits and growth for their own sake, Britannia was following a business model not dissimilar to those of HBOS and Northern Rock: borrowing from the wholesale markets to fund asset growth, frequently via mispriced risky lending, with an increasing interest in (large) commercial property loans.

Perhaps the aspect of the Britannia’s business model that made it most vulnerable in the crisis was its high reliance on wholesale funding. In the UK, building societies face a regulation that means they must raise 50 per cent of their funding from individual retail depositors. Everything else (wholesale borrowing from the short-term money markets and longer-term capital/bond markets , combined with non-retail deposits from other organisations such as local authorities) counts towards the ‘Funding Limit’. Britannia had the highest funding limit ratio of any building society at year-end 2008, and in all but one of the previous five years (it was still the fifth highest in 2005).

Just as they face regulation on liabilities side of the balance sheet, building societies are also limited in the kinds of assets they can hold: they must hold 75 per cent of commercial assets (liquid assets are excluded from this calculation) in the form of residential mortgages. Here too, Britannia was pushing the limit.

In 2008, the lending limit ratio was the highest for a UK building society. Though this was not true in previous years, the trend line is worrying: the Britannia was rapidly increasing the proportion of its lending not in the form of residential mortgages. A particular focus was commercial property, and rather than building up a portfolio of small, relatively safe loans to B&Bs and flats above shops, £900m of the £1.7 bn of ‘impaired’ loans is from just 12 big loans (Collinson, 2013: url, paragraph 1).

This is not to say Britannia were not also making lots of mortgage loans: in terms of mortgage lending as a percentage of prior year loans, Britannia were the 7th fastest growing building society 2007-2008. It appears that the decisions about who to lend to were not well made: 'Impared loans on a book of former Britannia mortgages known as 'Optimum' are running at 17 per cent--way above the industry average--with £1.2bn. of home loans at risk of going bad . . . Across the Co-op Bank’s whole mortgage book, 6 per cent of lending is classed as impaired. A further £1.1billion of loans are in ‘forbearance’, meaning borrowers in supposedly temporary straits have agreed a deal such as a payment holiday.'

In hindsight, these graphs and statistics show that Britannia went into the crisis with pretty much the worst business model possible. It would perhaps be OK if there had been profit in this model, and it was all being put into capital in case of the eventuality that things didn’t turn out well. Unfortunately, as the next graph shows, even as it continued to lend more and more, and in areas theoretically more risky for a building society, Britannia was making less profit per pound of lending (in other words, mispricing risk on a grand scale). I cannot believe that these graphs were not considered as part of a due diligence process (but, if you read the PR from the time you might conclude otherwise).

According to my analysis there are three broad reasons why the merger took place:
  • The Co-operative Group had long wanted to take on / offer an ‘ethical’ ‘alternative’ to the larger retail banks in the UK. It had identified various large building societies as routes to this objective, lobbied for the Butterfill Act and took the opportunity when it came, paying little or no heed to the realities of Britannia’s past or the unfolding financial and economic crises. This might also explain the wholly misguided project of taking on the Lloyds branches.

  • The Co-operative Group was interested in growing its banking operation (consistent with above). The senior management at the Co-operative Bank did the due diligence on Britannia, and decided that the risk was worth taking on. Such a conclusion would rely on an expectation that the UK economy would recover strongly and quickly, and that the turmoil in financial markets would end soon.

  • The Co-operative Group did the due diligence on Britannia and, given this and the deteriorating economic environment and continuing turmoil in financial markets, decided it would rather not take it on, but gave in to pressure from the FSA and government to persuade it to do so.
As far as I’m concerned Option 1 amounts to hubristic foolishness, Option 2 amounts to naive optimism and Option 3 amounts to dangerously craven weakness. The Co-operative Bank was facing a capital shortfall of £1.5bn. I personally cannot see how selling off great chunks of your business (life and general insurance arms), ceasing lending to new business customers, and undermining your brand by introducing external shareholders to what had been considered a ‘mutual alternative’ are going to combine to create a business model that can ride out the problems that remain.

Just about the only shining light for the Co-operative Bank is that, thanks to a reputation for customer service and an ethical stance, it has in the words of Frances Coppola 'an amazing customer base which has been astonishingly loyal'. Some of the Co-operative Bank’s customer base will remain loyal. However, for new customers (of whom there were apparently as many as 100,000 last year) this loyalty will be very shallow. Anecdotally, such customers feel betrayed and are already leaving. Even old and traditionally loyal customers may reconsider their relationship with the Bank following the introduction of shareholders and the associated incentives to maximise short-term profits, not to mention the revelations of previous bad management. If I were a retail customer, I’d certainly be thinking twice. Perhaps more to the point, I’d wager that larger borrowers and investors aren’t feeling too positive about the Co-operative Bank at the moment, and that won’t help them one bit.

But this isn’t the bad news. The bad news is that the UK financial crisis of 2007-8 was not solved, but merely deferred (much like the crisis of the 1970s that lies at the root of our current problems). The problems at the Co-operative Bank are just the beginning. Your money is probably safe (assuming you haven’t got very much), but our financial and economic systems still very much are not. The storm that is coming is as likely to selectively avoid particular ownership models in finance as nature’s storms are to avoid houses on the basis of whether they are owned by the occupier, a landlord or the local authority.


  1. This is great stuff Molly. I'd add in a couple of things.

    Firstly, a vignette. I attended the opening of the Co-op Banks new London offices on the edge of the City in around 2009. The main business being done there was the big corporate and asset deals. Looking for smalltalk with someone I was chatting with, I said how great it was for the sector that the Co-op Bank was growing and that the complimentary branch network meant this was a great deal all round (I was parroting the PR I'd read in the papers).

    My conversational colleague - who worked at a mid-level in the bank, some tiers down from the senior management - looked at me with pity and told me that Britannia was a basket case, and it had been rescued by the Co-op Bank, not merged. This was clearly known.

    My feeling is that the Bank were engaged in a hubristic growth phase Peter Marks had, it was said in co-op circles, made the Co-op bidding for Somerfield a condition of the merger with United Co-operatives which also saw him made group CEO. Every talk Marks gave was always about scale, scale, scale. It felt like the last throw of the dice for a 20th century retailer rather than a clear eyed view of what 21st century retailing might look like (hence his deep aversion to ethics, fairtrade, organic food etc). There was also an obsession with recovering market share - Marks always spoke of getting the Co-op back in the Premier League.

    I think this phase meant that when it became clear that Britannia was in trouble, they took a bet. They would have done Labour a favour (remember, there is a real closeness between Labour and the Co-op), and the sector as a whole; there was a degree of pride in the fact that the institutions which had been imperilled in the crash were either ex-Building societies of risky banks. For Britannia to go under or need bailing would have tarnished the sector.

    The due diligence would probably have said these were risky loans, but in 2009, there was an argument to be made that the economy was going to recover; what's holed them is that the economy has tanked, meaning the loans have gone more bad, more quickly. Obviously, the fact that the economy has gone bad was a predictable risk, but when people wanted to make this happen, they would have been looking for arguments to support the case, not giving strong weight to counter arguments that would caution greater risk.

  2. Hi Dave, this piece wasn't actually by Molly, but by me - Peter Pannier.

    First, thanks for commenting!

    Next, taking your points in turn:

    1. Re: your vignette, makes a lot of sense. It's a shame we don't have more whistleblowers in finance, huh? ;-)

    2. The closeness between Labour and the Coop is the subject of further writing I have drafted on this issue regarding its wider implications. You might find this interesting in the meantime: http://labourlist.org/2011/01/why-im-anxious-about-the-co-op-party/

    3. "For Britannia to go under or need bailing would have tarnished the sector."
    Not only that, it would have meant people would have stopped moving their money to 'safe haven' building societies, and potentially started taking it out pretty quick, and several more building societies would have been forced into rescue mergers or potentially even gone bust (and then think of the consequences for the mortgage markets, wider economy, etc... v. imp. politically to avoid this)

    4. Anyone making the argument that the economy was going to recover in 2009, well, I don't have a lot of time for, in short. Patently obvious to anyone who cared to look with blinkers off, as far as I'm concerned (admittedly as a very early-career academic/mainly self-taught economist), that this would not be the case.

    5. "people wanted to make this happen". I agree, but feat they wanted to make it happen so much that they didn't just look for arguments to support the case and not give strong enough weight to counter arguments, they willfully deluded themselves with incomplete information - not acceptable, and exactly what I am trying to caution against now.

    Thanks again for thoughtful comments!

  3. I am one of those sily people who opted to put a significant chunk of my pension fund equvalent into bonds of the Coop. I actively seek out what appear to me to be ethical companies, and the Coop bank appeared such.

    Now I am likely to lose at least a third of my savings and with it any prospect of retirement in the forseable future. Do you think I'm sore? You bet! Has the Coop blown its reputation with me, most assuredly. If investing ethically does this, then people are just going to ignor that dimension. Suddenly cigarette companies and arms manufacturers are starting to look a whole lot more reliable.

  4. Hello anonymous commenter - yes, the problems at the co-op will damage the idea of ethical investment, and people will end up moving their pension investments back to cigarette companies and arms manufacturers. Of course, the Co-operative was not always as ethical in its lending as it made out (calling the Lonmin min in South Africa where 34 workers were shot not so long ago "one of only two mining companies presently allowed in our Sustainable range of funds" http://preorg.org/the-co-operative-bank-ethical-investment-and-the-killing-of-34-people/, and being involved in a refinancing scheme for the expansion of Manchester Airport http://manchestermule.com/article/coop-banks-refinancing-of-manchester-airport-draws-criticism-from-environmentalists, for instance, not to mention the Group having it's own brand of cigarettes of course)

    So: in response to the inevitable "So what do you propose?" questions, and very briefly, here are a few things you can do: raise questions in and about the democratic participation structures of the Co-operative group (hyperlink: http://www.co-operative.coop/membership/have-your-say/) and join/get involved in your local credit union or small building society (and do the same). These are insufficient, but practical actions it is easy to take, if you have to put or borrow money from somewhere.

  5. I've been with the co-op since the 80's and have encouraged the development of its ethical policy. When the co-op announced plans to take over Britannia I was dismayed because in my view, one of the reasons the Co-op- as a commonly held resource by members not private owners- has been able to successfully sustain an ethical business practice is because its stayed small relative to the other high street banks. Growth is destabilising. There is a natural optimum size for all activities relative to their environment, be it a garden, a herd, a cake mix or a bank. If it gets too big it collapses. The Co-op board have lost sight of this basic fact. Elinor Ostrum identified some principles that a commonly held resource needs to adhere closely to, to be sustainable. Size is one of these principles: Analysing the design of long-enduring common resources and institutions, Elinor Ostrom identified eight design principles which are prerequisites for stability and sustainability in what she called "Common property regimes" (like the Co-op Bank):
    1. Clearly defined boundaries
    2. Congruence between appropriation and provision rules and local conditions
    3. Collective-choice arrangements allowing for the participation of most of the appropriators in the decision making process
    4. Effective monitoring by monitors who are part of or accountable to the appropriators.
    5. Graduated sanctions for appropriators who do not respect community rules
    6. Conflict-resolution mechanisms which are cheap and easy of access
    Minimal recognition of rights to organize (e.g., by the government)
    7. In case of larger CPRs: Organisation in the form of multiple layers of nested enterprises, with small, local CPRs at their bases.
    You can find out more about Elinor Ostrum at www.elinorostromaward.org

  6. An excellent point Miriam. I would concur (or rather, also defer to Ostrum) regarding size and commons management. However, it should be emphasised that the Co-operative *Bank* was never owned by customers. Rather, it was owned by the Co-operative *Group*, which in turn was owned by member-societies, in turn owned by customers. As I understand it, anyway...

  7. So where should the citizen looking for ethical banking now turn?

  8. Thank you Peter, very interesting. I've been a Co-operative customer for several years, holding a current account and a savings accounts. I also bank with Triodos (saving account) who I consider more ethical than Co-op/Smile, but unfortunately they do not offer a current account I think on the grounds that the regulations mean for their size of bank they need to hold very high amounts of capital. I unable to work out whether the regulations are good here, or too harsh!

    Anyway, I have chosen to stick with Co-op for now, but only just, as I feel they have lost a good chunk of their Ethical status. Also, I don't see the economy growing for a long time so expect to see more commercial loan losses. But I don't see another ethical option, though I would consider a well run building society (if I could work that out!). I would ideally like a branch I could walk into. The Co-op offers me this (though 10 miles away). Most of the building societies I've looked at offer much poorer interest rates for branch based accounts rather than online accounts.


  9. I am a British expat living in the USA and have an offshore account with the Co-op at their Guernsey Branch. Recently they wrote to me telling me that they were closing this branch and were discontinuing offshore banking and they would contact me soon to detail my options.

    A couple of weeks later I recieved a call from one of the employees in Guernsey to let me know what my options were, in a nutshell "take your money and go". I asked if they could just transfer my account to an ordinary one on the mainland the answer was no, you dont have a UK address. he then went on to moan about the fact he was losing his job ( I have some sympathy for him indeed so perhaps not the best person to be dealing with their customers.
    So there you have it customers of some years being told to take their money and hop it, which I am now in the process of doing. Loyal to their customers, dont think so!

  10. A thoughtful and very informative article, followed by interesting and sometimes sobering comments. Congratulations to Molly for this post.