A Period of Transition

Posted on March 31, 2014 · Posted in Co-operative News

This is a period of substantial transition not just for the Co-operative Bank, but also for the Co-operative Group.  Not the least of this – though it has passed with surprisingly little comment – is the de facto move of decision-making from Manchester to London.  Group directors and senior executives are now based in St Paul’s, a handy stone throw from the London Stock Exchange.

 

Several staff within the Group have indicated their unhappiness at this change, for some of whom it means moving either home or job.  Even the public relations function for the Group is to be led by an outsourced firm in London.

 

Disentangling the affairs of the Bank and the Group is just as troublesome.  The prospectus for the Bank made clear there were three main challenges: the IT system, pensions liabilities and Corporation Tax.

 

The Corporation Tax issue is simple, if painful.  For the last two years, the Group’s Corporation Tax payments on their profits have been mitigated by the losses taken by the Bank.  As a result of the separation of Bank from Group, the Group is no longer able to mitigate its tax liabilities in this way.

 

Pension liabilities are also apparently very difficult to separate between Group and Bank.  In fact the pension scheme’s summary funding statement from last year makes clear that the pension fund is in painful deficit – though the significance of this should not be overstated given the much larger deficits incurred by many other private sector pension funds.

 

As at 2012, the pension scheme for the Group – including the Bank – was in deficit by £817m.  This was up sharply from the £248m deficit in 2010.  Although the value of assets rose in that period by £853m, liabilities rose by even more – by £1.4bn.

 

The pricing of liabilities rises as the yield (interest rate) on government debt falls.  To put it simply, it is assumed that it becomes more expensive to meet future liabilities if interest rates are low.  This may be regarded as an accounting issue, rather than necessarily a funding issue.  We can be confident that interest rates will rise in future years, this will push up the yield on government bonds (called gilts) and that in turn will pull down the assessed cost of meeting liabilities.

 

However, the Group has recognised that the pension scheme also needs an increase in funding.  As a result both scheme members and the Group had to increase their contributions.  Ultimately, though, the Group is underwriting the pension scheme’s liabilities, not only for Group employees but also for Bank staff, up to the date of the separation.

 

In saying this, though, the column is assuming that the Group will deal with the current difficulties and will continue trading.  It was noticeable, however, that when John Mann MP addressed the recent Co-operative Ways Forward conference, organised in Manchester by Co-operative Business Consultants, he suggested many people in the City of London had doubts about the future of the Group itself.

 

The third problem area is the IT systems.  Here seems to be the biggest challenge of all.  As a result of the ill-fated Project Unity – which brought Group and Bank together – it is extremely difficult and perhaps impossible to split the IT system into different parts.

 

This is not just true for the Bank and Group.  I am told that there are similar and serious problems in trying to separate the IT systems for the life assurance business, already sold to Royal London, from that of the Group and Bank.  While my understanding is that the reason for abandoning the sale of the general insurance business is that the capital on offer just did not make a deal worthwhile, it is suggested to me that difficulties in disconnecting the IT system was another factor.

 

The IT integration issue is not just a practical difficulty.  It is, I am advised, also a potential legal problem.  The Group and Bank are now separate legal entities, yet the IT system cannot be separated.  Moreover, Mark Taber of Fixed Income Investments – who lobbied successfully on behalf of the small retail bondholders for a better deal as part of the Bank restructuring – has alleged that the costs of the IT system have not been properly allocated to the different parts of the business.  He claims that this has disadvantaged the Bank, in effect contributing to the size of its losses.  A source within the Group confirmed that this may be the case.

 

Mark Taber told us: “The IT system costs were incurred by a separate Group management company and recharged to the operating companies. I suspect that the system was intended to integrate various parts of the financial services group – ie Bank, general insurance and life insurance – to join up customer relationship, account management, marketing, etc. But then it seems all the costs have been charged to the Bank rather than the insurance companies which, of course, they were selling / trying to sell.”

 

Taber added that he endorsed recent testimony of Andrew Bailey, deputy governor of the Bank of England, to the Treasury Select Committee.  Bailey told the MPs: “the losses on the write-off of the information technology transformation programme…. which I think are now about £598m, are hugely larger than anybody could have expected. How this came about is one of the stories that needs to be revealed by the investigations because, I will be honest with you on that, I still do not understand how it is possible to have ended up in [that] situation.”

 

Taber continues: “Like Andrew Bailey I don’t understand how it is possible for a small bank to spend £598m on an IT system which was not even completed or implemented.  It seems likely that a substantial proportion of that cost must have related to other parts of the Group. Hopefully the investigations will get to the bottom of what happened.”

 

It should be remembered that in addition to this nearly £600m write-off, the new Co-op Bank IT system will cost a further £500m.  These are vast sums of IT expenditure, compared even to that spent by the very largest UK banks.

 

But the attempted stripping-out of IT systems by no means brings to an end the structural change at the Group or Bank.  The ongoing strategic review is likely to suggest further and substantial reforms.  We now know, thanks to testimony to the Treasury Select Committee, that the Group in recent years has considered selling-off both the farming portfolio and the retail pharmacy business.  It is also significant that there have been a number of senior changes of personnel within the retail division, below director level.  There are also moves to streamline the management structure within retail.

 

In terms of structure, we can also expect there to be close examination not just of trading activities, but also the vast number of companies within the group – about a hundred – and the numerous brands.  Just why the Bank took over the Britannia to take advantage of synergies in order to cost cut and then maintain the Co-operative and Britannia brands (plus Smile) is beyond me.  In some places Co-op and Britannia branches are retained within a few metres of each other.  Bizarre.

 

Nor is the integration with Somerfield complete.  In places this has caused problems and the size of many of the Somerfield stores does not fit with the urban medium sized convenience stores that have provided the Group with its biggest sales growth last year.  Several of the former Somerfield stores are currently up for sale.

 

Here we come to what might be regarded as the nexus of the problem for the Group over recent years.  It grew through the acquisitions of Somerfield and Britannia.  Integration of both has been difficult and in the case of Britannia absurdly slow.  The cost of the debt for buying Somerfield has meant that the Group could not afford to rescue the Bank.  Meanwhile, the advantages of the acquisitions have not been realised because of the slow pace and difficulties of integration.

 

Yet at the same time when there should have been integration of the acquired businesses, there was instead integration of the Group and Bank, through Project Unity.  This no doubt impeded the other integration programmes.  However, integration of Group and Bank was itself misguided, because it failed to take into account pressures from financial regulators to ring-fence banking operations from other businesses.

 

The Group is now launching a ‘Have Your Say’ consultation.  It will be interesting to learn what customers – including readers of the News – have to say.  Some of the responses may well be pretty hard hitting.