Is it farewell to Kent Reliance?: Co-operative News

Posted on November 20, 2010 · Posted in Co-operative News

I hope that by the time you read this, the proposal to transfer the operating business of the Kent Reliance Building Society to a new PLC banking subsidiary will have been defeated in a members’ vote.  There is a reasonable chance this will happen, as it only requires one in four voting members to reject the option for it to fall.  But there is also a strong chance that the proposal will be successful.

 

Now please bear with me – though I realise that some readers will be turned off by me returning to this subject yet again.  I make the plea to read this because I believe this proposed transaction is one of the most significant and damaging initiatives affecting the UK’s mutual sector in its entire history.  This is why mutuals around the world are watching developments here – and doing so unhappily.

 

I have now been sent a copy of the Kent Reliance Building Society transfer document and at last we can see exactly what the details in the plan are and what this means for the future of mutuality in the society.  And, as we feared, it is a Trojan horse that could wipe-out much of the mutual sector in the UK.

 

The new banking subsidiary will be a PLC, called One Savings Bank.  Under the deal, JC Flowers (under the name JCF Holdco) will invest £50m into One Savings Bank, obtaining 40.1% of ordinary shares in the joint venture.  Initially, KRBS (or more strictly KRPS – the Kent Reliance Provident Society) will hold 59.9% of ordinary voting shares.  But JC Flowers will also hold preference shares which could be transferred into ordinary shares, giving it a potential total of 65.8% of ordinary shares.  

 

The JC Flowers shareholding could rise further, to 75%, if additional capital is required from the private equity firm.  The transfer document comments on this possibility.  “The Board’s view is that a significant adjustment is likely to be required [ie extra capital] at the time of investment as a result of likely write-downs in the commercial loan portfolio, but this is not likely to increase the JSF Holdco holding of total issues shares in the Bank to more than 75%”.

 

The document also explains: “KRPS’s shareholding would be diluted if JCF Holdco is issued with further preference shares as a result of successful claims for breach of warranty or shortfalls in recoveries by the Bank under its commercial loan portfolio”.

 

If and when the KRPS shareholding becomes diluted, so it will lose various rights.  In particular, the number of directors nominated by KRPS reduces.  Specifically, the chief executive and chief financial officer are only appointed by KRPS while it holds the majority of ordinary shares.

 

Even if JC Flowers do not get control of the One Savings Bank, it is assured of a strong return on its investment.  Should KRBS be required to buy JC Flowers out, it will have to pay a price representing an annualised 20% rate of return on the private equity firm’s investment.

 

It is worth considering how KRBS got into this situation.  The transfer document helpfully gives us some clues.  In each of the years ending September 2006 and 2007 it reported strong profits – £5.9m pre tax in 2006 and £5.7m before tax in 2007.  Serious problems began in 2008.  While the society recorded a pre-tax profit of £14.1m, it also reported impairments on its loans of £4.1m.  In 2009, net profit fell to £3.8m, while impairments remained high at £3.6m.  In the first seven months of the 2010 year, net interest income was reported as negative – because the continuing interest environment was hitting income badly – and there was pre-tax loss of £4.7m. 

 

Given the comments in the transfer document about the society’s commercial loan book, we can no doubt expect further impairments to be reported in future years.  Significantly, the society’s accounts also show a much increased exposure to derivatised securities, which are not performing well.  Gross capital is now just 5.54%, which is insufficient for the society to offer much in the way of new mortgage lending.  The society expects to continue in loss making territory for the foreseeable future and unable to build up its capital position as is required by regulators.

 

If the new deal goes ahead, it is assumed that One Savings Bank will become the vehicle of the rationalisation and effective demutualisation of a range of other financial institutions.  Those in the line of sight may include the nationalised bank Northern Rock, the Irish nationalised former building society EBS (which is also the target of another private equity firm) and the Skipton, West Bromwich, Norwich & Peterborough and Principality Building Societies.

 

There are two main drivers for this possible rationalisation and restructuring.  One is obviously the desire of JC Flowers to enter the banking market and to unlock residual ‘value’ from building societies.  The second is on the part of the societies (which, other than KRBS, may not be interested in any offers) that need injections of capital to meet new regulatory obligations and to improve economies of scale.

 

That second objective could have been achieved without the involvement of a private equity house and its rapacious desire for super-profits.  Economies of scale have already been achieved by some small building societies through merging back office functions.  There was, and still is, scope for further rationalisation to improve efficiencies, without diluting ownership independence.  Similarly, societies could come together to create pooled reserves, to meet capital adequacy requirements without losing their mutual status.  Alas, it seems as if this option is not being properly considered and investigated.  It is not even mentioned in the KRBS transfer document.

 

Instead, we have the prospect of JC Flowers taking over much of what is left of the mutual sector.  And, to add salt into the wound, committing itself to co-operative principles while doing so.  “The bank’s articles of association will provide that its core purpose is to provide a range of financial services to members of KRPS and other customers in support of its co-operative principles,” says the proposal.

 

That glib statement may be sufficient to persuade regulators and those KRBS members who have little knowledge of how a building society or other mutual should work.  But it leaves me deeply unhappy and I cannot believe it will satisfy many members of the News.