All Change at the Co-operative Group

It’s not just a change of leadership at the Co-operative Group and Bank.  While it is not quite a clear out, it is less a reform and more a revolution.  Not only do we have a new cadre of leaders, but they are people who have been successful elsewhere.  The emphasis is on quality, rather than a background in the movement.  It has not always been that way in the consumer co-operative sector.


Euan Sutherland has demonstrated as the new chief executive both his authority and determination by overseeing a range of other appointments.  Some changes were necessary, because of planned retirements and personal circumstances, but others were deemed essential as part of the revamping of the Group and, in particular, to move the Bank through its current difficulties.


Richard Pennycook becomes Group Finance Director, in place of Steve Humes.  Pennycook was previously Group Finance Director at Morrison’s, where he is regarded as having overseen a very positive transformation of a supermarket brand that had been regarded as tired and was then over ambitious in seeking a recovery.  His success at Morrison’s might be seen as perfect preparation for his role at the Group.  But it is also a strong sign that despite the pressures at the Bank, the Group will not lose focus on its core retailing operations.


Meanwhile, Paul Flowers has stepped down as Chair of The Co-operative Banking Group, replaced by Richard Pym.  Pym is also extremely well qualified for the specific role that he moves into.  He remains chairman of UK Asset Resolution, the holding operation that oversees the transformation of the ‘bad’ banking operations of Northern Rock and Bradford & Bingley into hopefully turned around businesses.  He has also been group chief executive of Alliance & Leicester.


Even more significant is the appointment of Niall Booker, who becomes both Chief Executive of The Co-operative Bank and Deputy Chief Executive of The Co-operative Group.  Booker was a senior banker at HSBC, where he was Group Managing Director and Chief Executive Officer of HSBC North America.  In his roles there, Booker had responsibility for resolving difficult regulatory issues arising from serious control weaknesses in the bank’s North America operations.  Before that, he was chief executive of HSBC in the Middle East.


The nature of the appointments, the backgrounds of the new directors and the early starting date for them taking up their posts, underlines the seriousness of the current situation.  It is one where the new regulator with responsibility for the health of individual institutions – the Prudential Regulatory Authority – is closely monitoring.


The PRA will have been involved in the appointments. Senior positions at financial services firms are subject to approval by the PRA, which assesses whether a person is fit and proper and has the appropriate skills and experience for that role.  It is telling that all the recent appointments have passed this hurdle – which is far from simple.  Earlier this month, the head of audit of one of the UK’s largest accountancy firms was regarded by the PRA as having insufficient industry experience to go forward as finance director of Legal & General.


The involvement of the PRA in the affairs of the Bank and the Group go beyond the appointment of key individuals.  The Financial Times has reported that the Bank has a capital shortfall of £1bn, while Barclays has suggested it could be as much as £1.8bn – though this figure is regarded by the Bank as unduly pessimistic.  The PRA wants evidence that the Bank and Group are putting together a package that will cover the £1bn or so capital gap.


There are three elements to addressing the Bank’s undercapitalisation.  The first is from disposals.  The life assurance business acquisition by Royal London for £219m has now been approved by the mutual insurer’s annual general meeting and so can be completed.  The general insurance business is now up for sale and Morgan Stanley has suggested that this might generate £277m – some way short of the £650m some in the financial press were reporting earlier in the year.


There are also some disposals of loan portfolios that are regarded as non-core.  These comprise good quality loans to housing associations, along with portfolios that contain loans of poorer quality – buy-to-let mortgages, some commercial property lending and sub-prime home loans.  These are the areas of lending that damaged the Britannia Building Society and now represent the poison inside the Co-operative.  Selling these portfolios will be more difficult and some may need to be held for the medium to long term for their value to rise.


The second focus of the turnaround involves actions that the Group might take.  This could involve sales of lines of business, enabling capital to be transferred to the Bank.  Understandably the Group is reluctant to take this course of action.  Selling the funerals or pharmacy businesses to support the Bank does not look like a good idea – especially as pharmacy is an activity underscored for growth and which is benefiting from past investment.  Similarly, the Group will not want to dispose of a new business operation, such as legal services.


A more attractive support mechanism would be to transfer the Bank’s pension fund – which carries a deficit – onto the books of the Group.  This would improve the state of the Bank’s balance sheets, without involving the transfer of any cash. 


But it is the third area of focus that has hit the headlines in the mainstream press, which is likely to see bondholders’ investments diminished.  There are two classes of bonds that could be affected – and ultimately the PRA may insist on these investors taking a hit.


The former Britannia Building Society issued Permanent Interest Bearing Shares (PIBS), of which about £310m have not reached maturity.  Although these are called ‘shares’, they are actually equivalent of a bank’s junior bonds and so do not rate highly in priority amongst creditors.  Interest on them is a fairly generous 5.5%, reflecting their risk character.


In addition, there are about £60m of ‘deferred shares’ issued by The Co-operative Bank, also prior to merger with Britannia.  Holders of both sets of bonds should be happy that they have just received their latest dividends.


At present, both sets of bonds are being traded on the securities markets at a discount of about 30% on cover value.  This may explain why the financial press has speculated that a restructuring of the Bank may involve bondholders having to concede a 30% reduction in the face value of their bonds.


Any restructuring involving a hit against the face value of the bonds will have to be with the voluntary agreement of the bondholders.  These are mostly institutional investors, who are likely to see this as the best way forward.  But there are also several thousand small investors, presumably including many people with a background in the movement, such as readers of the News.  Co-operative societies are also likely to be exposed, though the Bank was unable to provide any details on this.


Although this would constitute a ‘voluntary restructuring’, the absence of a clear alternative that would also keep the Bank within the mutual sector may mean there is little resistance to it going through.  However, there will be a lot of unhappiness.  There is a precedent – bondholders in the West Bromwich Building Society also took a painful hit after it hit trouble from losses on higher risk lending.  Here, too, the regulator was involved in finding a solution that did lead to demutualisation.


This is all very uncomfortable for the Bank and Group, but it does chart a route for not just survival, but also growth – providing the new leadership cadre prove their worth.  If they do, the movement may reflect that the focus on quality rather than time serving is no bad thing.


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