What went wrong at the Co-op

Posted on September 18, 2014 · Posted in Society for Co-operative Studies

What went wrong at the Co-op

In 1960s, Co-op societies had a 25% market share in the grocery trade, making them collectively the UK’s largest grocer.

By the early 1990s market share had fallen to 15%.

Gradually market share fell further as the big supermarket chains – led by Tesco – overtook the co-op societies.

We can put this decline down to several factors:

Abolition of resale price maintenance (for which societies had lobbied)

Complacency

Poor quality store management

Failure to nurture talent

Executive dominance over non-executives

Failure of strategic vision and leadership

There was arguably a secondary factor, the increased disconnection between societies and their memberships:

The divi was ended in most societies (flowing from end of RPM)

Elections were often controlled by senior managers, who instructed staff on how to vote

There was a loss of competence amongst the elected directors, which mirrored the low levels of competence amongst mid-tier management and even senior management in some societies.

If we jump forward to 2007, Co-op Group merged with United Co-operatives to form the enlarged Co-operative Group.  As part of a recent trend, in order to seal the deal the CEO of the smaller business became CEO of the merged business.  That was Peter Marks.

Marks believed, to the point of obsession, that the solution to the co-operative societies’ problems lay in combining and through mergers and acquisitions.  The Marks mantra was that the Co-op Group should only compete in markets where it could achieve “scale”.

In 2009 the Group paid £1.57bn for Somerfields, doubling its market share.  This was largely paid for through borrowings, creating the basis of the debt problems that have contributed to the recent crisis.

There is a belief in businesses that mergers and acquisitions can be positive strategies in a growing economy, but a potential disaster in a contracting economy.  The acquisition of Somerfield and also of Britannia took place in 2009 – just as the economy was crashing.

There were other problems with Somerfield acquisition.  Somerfield itself was insufficiently coherent as a grocery business, without a clear market position.  Many of its stores were too large to be used as convenience stores, the Group’s modern market position.  Many of the stores were tied into expensive, long term leases.

Today the Group still holds leases on over 600 empty retail units as a legacy of the Somerfield takeover.  This creates an annual lease cost of nearly £500m.  60% of these should have been disposed of by next year.

The grocery retailing business remains in decline, although still the fifth largest food retailer.  In the quarter ending August its market share fell from 6.6% to 6.4%.

It is reasonable to consider the Somerfield acquisition to have been a disaster, but the Britannia deal was a bigger disaster and almost brought the Group, as well as the Bank, to collapse.

To compete adequately, the focus of the Bank was expansion.  Initially by taking over the Britannia Building Society and subsequently Project Verde, branches of Lloyds TSB that were required to be disposed of under state aid rules.

The Bank had become seen as a major contributor to total Group profits.  For example, in 2011 the Group’s total operating profit was £585m.  Of this £216m came from financial services, including the Bank, despite it having a much smaller market share than the food business.

However, it is not clear to me that the Group was aware of the level of real risk it had become exposed to in trying to expand the Bank.  Profits were high compared to grocery retailing, but at the expense of a much higher risk exposure.

What most of us failed to notice was the risk involved in taking over the Britannia Building Society.  The Group / Bank had already pulled out of a proposed deal to take over the Norwich and

Peterborough Building Society, because the Norwich & Peterborough didn’t look very attractive when the figures were looked at closely.

Due diligence of the Britannia failed to notice any big problems.  KPMG, auditor to the Bank and Group for decades, undertook most of the due diligence.  The Bank itself did the due diligence on the commercial loan portfolio – which is the loan book that has since gone wrong.  According to a prospectus quite recently published by the Bank, the problems of the loan were related to over-exposure to too few trading sectors and too few borrowers within those sectors.  So it seems that the Co-operative Bank that was not aware enough of its own risk exposure was taking over a building society that had an unwise approach to risk exposure.

In fact, the regulator already regarded the Britannia as a basket case and treated the Co-operative Bank as a rescuer of the Britannia.

Andrew Bailey, Financial Services Authority, evidence to Treasury Select Committee:

“Yes, it [Britannia} would have failed. The merger essentially took it out of the limelight and in that sense it achieved its objective.  Britannia was one of the building societies in 2008 and 2009 that was in trouble.”

The minutes of a meeting in July 2011 between the regulator and the bank’s full board and senior management team show that Andrew Bailey, the FSA’s director of regulation for banks and building societies, “wished to use the opportunity to provide the Board with strong messages about the bank’s capital position, the serious concerns that FSA retained following the significant misreporting of its liquidity position and on the weaknesses in CFS’ risk management”.

Bailey explained “it had come to light that CFS had significantly overstated its liquidity position by misreporting the maturity of corporate accounts”.   Neville Richardson denies this.

In that same meeting, the regulator made clear that it did not believe the Co-op Bank was up to the job of taking over 632 Lloyds branches under Project Verde.

Three years ago, the people who needed to know did know that the bank was not capable of effectively carrying out the Verde acquisition and, moreover, that the regulator believed there was serious financial misreporting by the bank.

Sir Christopher Kelly’s review:

“At no time between the Britannia merger and the spring of 2013 did the Banking Group Board have in place a Chief Executive with appropriate experience. In 2009, at the height of the banking crisis, it appointed Neville Richardson. He had no previous experience of a senior leadership role in a bank and had presided at Britannia over the creation of the high risk BCIG portfolio, including the subsequently toxic commercial real estate lending….  Neville Richardson’s appointment appears to have been presented to the Banking Group Board as a condition of the merger.”

The causes

The £1.5bn capital shortfall was caused by:

bad commercial loans issued by the former Britannia Building Society,

provisions for compensation for the mis-selling of payment protection insurance

write-offs of past spending on IT systems,

the need to set aside substantial sums to procure new IT systems.

Other factors were:

Weak executive leadership

Weak non-executive leadership

Incoherent and inconsistent strategic direction

Project Unity

Interference by Group executives in the management of the Bank

Toughened capital obligations from the regulator

In addition, use of the Butterfill Act for the merger led to a lack of access to capital markets, in contrast to building societies that could use core capital deferred shares.

The wisdom of former Group CEO Peter Marks:

“A flash headquarters can be a sign of a bloated corporate ego. It should instead be seen as a symbol of the Co-op’s modernisation.”  2012

“I guess it [the Bank] was a victim of the economy,” said Marks.  2014

Sir Graham Melmoth:

“Peter Marks would not know a co-operative principle if it crept up and hit him in the face.”

A.N. Other co-op movement leader:

“Peter Marks would not know a risk if it hit him in the face.”

The legacy

Disposals since 2005:

Life insurance

Asset management

Farms

Pharmacies

Travel

Sunwin (cash handling and ATM management)

Car dealership (part in 2005 and part in 2013)

Optician (in 2005)

Bank