Open letter to Cathy Jamieson MP, Jonathan Evans MP and Baroness Maddock, joint chairs of the All–Party Parliamentary Group on Building Societies and Financial Mutuals.
Dear joint chairs,
Firstly may I congratulate you and your colleagues for your membership and leadership of the all-party group. It has previously published an important piece of work on the demutualisation of building societies, in which you reported the damage inflicted on the very members of those societies in whose name the demutualisations were supposedly carried out. I hope and trust that your latest work on corporate diversity in financial services will be of similar significance.
You also deserve congratulations both for inviting the chief executive of the Financial Services Authority, Hector Sants, to give evidence to your committee – and for being successful in persuading him to attend.
I am writing this letter to stress just how vital it is for the future health of the financial services sector as a whole – and not just to the financial mutuals sector – that the FSA recognises that it needs to adjust its regulatory regime to take into account the specific characteristics of financial mutuals. While the FSA is now organising its own run-down and replacement as a financial regulator, it is to be hoped that it (and your own group) will assist the new regulators to learn from recent history.
You will, of course, be aided in your work by the excellent report from Professor Jonathan Michie, ‘Promoting Corporate Diversity in the Financial Services Sector’. In this, Professor Michie argued effectively that financial mutuals should have a key role as providers of plurality and as protectors of consumers. He also explained that other countries have been better in understanding that key role, retaining stronger co-operative banking sectors.
A fundamental principle of the effective operation of the capitalist system is that companies must be able to fail and that companies must not be able to grow to a size where they can dominate their markets. Without that structure, there is no proper method of competition. Unfortunately, banks were allowed to grow to a size where they became ‘too big to fail’. It is to be hoped that regulators in the future will take action to ensure banks operate at a more appropriate size – and also to protect large and small financial mutuals from being taken over by big banks.
With the benefit of hindsight it is clear that the demutualisation of building societies such as Halifax, Bradford & Bingley and Northern Rock was a serious error. This was not just a mistake by members and directors: it was also a mistake by regulators and policy-makers. The scale of the destruction of our economy brought about by these and other financial institutions is self-evident proof that there should have been intervention to prevent the demutualisations, rather than governmental encouragement for this.
We are today faced with the threat of a new round of demutualisations, though they are cloaked in the facade of joint ventures and rescues from the private equity house, JC Flowers. There is a serious risk that the effective demutualisation of Kent Reliance Building Society will be followed by others. This is the result of two factors: weaknesses in societies’ business models and the lack of an appropriate alternative system for raising capital for financial mutuals.
Obligations imposed by the FSA and global financial regulators, co-ordinated by the Basel Committee, have created specific difficulties for financial mutuals. These tougher rules oblige institutions to increase their holdings of capital reserves to meet possible future losses. While PLC banks can meet these requirements by issuing additional shares, there is no similar opportunity for mutuals – for whom demutualisation is one of the few routes to meeting the tougher capital obligations. This is unfair, as co-operative banks and other financial mutuals played no significant role in the global financial crisis.
The Financial Times has undertaken very useful research on the way that co-operative banks in other jurisdictions have developed means to pool capital reserves, to meet the needs of regulators. Other research on the same theme is taking place at present and it would be very helpful if the FSA could recognise its significance and take a sympathetic approach to interpreting capital adequacy rules.
But supportive as I am to financial mutuals, it is important to recognise that several building societies adopted business models that were incompatible with their objectives. Instead of taking a low risk approach to financial management and focusing on their ability to borrow and provide home loans on a sustainable basis, they instead engaged in excessive use of securitised mortgages; loaned too much against commercial properties; and provided mortgages against self-certified declarations of income and even for amounts above the value of the property on which the loan was secured. In future, building society members should be better protected from the excesses of their own executives.
It is good that financial regulators are to liaise more closely with auditors of financial institutions. In doing so, may I suggest, auditors should make a more rigorous assessment not only of the performance and sustainability of any client that is a financial mutual, but also its adherence to its own objectives. Too often, financial mutuals have departed from these.
In the spirit of this tougher approach to regulation, it should also be recognised that the FSA has become more closely involved in corporate governance oversight. Directors of financial institutions are often now interviewed by the FSA prior to their appointment. I hope that this level of oversight will continue – and extended so that directors of financial mutuals are required to demonstrate their commitment and knowledge of mutuality, as part of their evidence that they are fit and proper people to be directors of that institution.
While tougher obligations obviously most apply to large organisations, consideration should also be given to smaller ones – particularly credit unions. My good friend Mark Durkan MP has stressed his anxiety that while the FSA has now come to terms with the culture and reality of how credit unions operate, this knowledge may well be lost when the FSA is replaced. It is essential for the health and viability of credit unions, that they are treated in a different way from a large banking PLC. At the same time, they should be given proper oversight.
The same applies to other providers of micro-loans. Too often, consumers are mis-led or face unfair pressure (or worse) to repay micro-loans provided by disreputable parts of the private sector. These lenders should face far more scrutiny. It would be unacceptable if the greater focus on macro-regulation and on detailed regulation of large financial institutions allowed rogue financial lenders to get away with improper trading practices. While the phrase ‘micro-lending’ sounds very sweet and fluffy, there is growing recognition that too often it is the lambswool disguise worn by wolves.
To summarise, perhaps I might be so presumptions as to suggest a checklist that financial regulators could take into account. (1) There should be a specific obligation upon regulators to promote and protect diversity in the provision of financial services, recognising that financial mutuals are an essential element of the competitive environment in that market. (2) Capital adequacy rules are discriminatory against financial mutuals, which are unable to raise forms of capital in the market that meet these criteria, so there is a need for financial regulators to assist with innovative solutions that protect diversity – including through allowing financial mutuals’ access to pooled reserves. (3) That demutualisation has been very damaging to the fabric of the UK’s financial system and that regulators should act to prevent future demutualisations, other than in very exceptional (and currently unforeseeable) circumstances. (4) Stronger oversight should be placed on the directors of financial mutuals, including tough examination of their credentials in the mutual sector and their understanding of the principles of mutuality – as well as their skills in, and knowledge of, the financial sector. (5) Future regulators must have a proper understanding of the specific operating environment of the credit union sector, being both sympathetic and demanding in their oversight. (6) Regulators must act in a fair but tough way to private sector micro-lenders, to protect the interests of consumers. (7) Regulators should work closely with the auditors of financial mutuals to ensure not only that societies have sustainable business models, but also that they operate in accordance with those societies’ commercial and social objectives. (8) Discrimination against building societies inherent in the mechanism used to calculate levies to the Financial Services Compensation Scheme must be addressed: it is wrong and achieves the wrong result for levies to be based on a simplistic percentage of deposits held, rather than a measure more closely associated with the risk-profile of an institution.
I wish your members well in their questioning of Mr Sants. It is my sincere hope that your eventual report will assist in not merely protecting what is left of financial mutuality in the UK, but will actually provide the foundations for it to grow again into the healthy and significant sector that it once was.
Yours sincerely,
Paul Gosling,
Columnist, Co-operative News