Building societies face new threat: Co-operative News

The threat to the continued existence of the building society sector as it has been known historically makes this one of the most significant, and negative, points in the history of mutuality in Britain.  So it is with this explanation, rather than an apology, that I return to the subject once again.


Kent Reliance Building Society is in negotiation with the JC Flowers private equity house for the creation of a new industrial and provident society, into which the existing building society would transfer.  The importance of the IPS structure is that this allows the creation of a mutual structure that includes some external equity. 


This is a wheeze that I had never considered when I previously welcomed the Building Societies (Funding) and Mutual Societies (Transfers) Act, 2007 – more commonly known before enactment as the Butterfill Bill, after its promoter, the Conservative former MP Sir John Butterfill.  The Act, it seems, is an enabler of partial demutualization.  It is the same process that was used for the transfer of Britannia Building Society to the Co-operative Group.  The Kent Reliance deal, though, would be a much more controversial step, which was not foreseen by those who drafted the Buttefill legislation.


While the Kent Reliance transfer requires member approval before it can go through, we already know the basis of it.  In return for the transfer of the business of Kent Reliance to the IPS – which might be regarded as a ‘special purpose vehicle’ to enable this to happen – JC Flowers will inject about £50m into the operation initially.  How the private equity firm would extract profits is a mystery to me, but presumably a clever device to achieve this has been theoretically constructed.


Kent Reliance is understood to argue that the proposed arrangement is not to prop it up.  However, we know that Kent Reliance could – to put it carefully – benefit from additional capital in order to pursue its existing expansionist business plan.  It is reported that the extra funds would assist the IPS to take over or rescue other building societies and it is rumoured that the first of these would be EBS (formerly the Educational Building Society), which has been rescued by the Irish government.


With the prospect of more building societies bundled into this IPS ‘vehicle’ because of the need for extra reserve funds we can once more see the problems related to the much higher capitalization obligations imposed by regulators as a response to the global financial crisis.  As I have said on numerous occasions previously in this column, if mutuals had stuck to their traditional operating model of lending on a low risk basis, taking a conservative view of property values, avoiding securitizations, not awarding loans on the basis of self certified declarations of income and limiting loans to a significant level below the market value of the property then they would not be in this mess in the first place. 


A more mature response to the crisis might be that if societies adopt a truly low risk business model they would not need to meet the much higher levels of capital – with capitalization requirements linked to an objective view of risk profile.  Alternatively, a structure might be used where societies and other financial mutuals have shared access to a capital pool – though this, too, would need to be linked to moderated risk exposure.


Incidentally, I wonder if building societies have, in part, been persuaded to reduce their levels of capital in response to the carpet bagging campaigns during the Thatcher and Major years.  By limiting the level of capital they held, while using profits to hold savings rates up and lending rates down, building societies assisted with their competitive edge and made themselves less attractive to demutualization campaigners. 


Adrian Coles, director-general of the Building Societies Association, shares this analysis.  “I think the answer is yes,” says Adrian.  In response to the carpetbagger threat and the demutualisation windfalls, building societies wanted to show that they provided a better deal for their customers than PLCs.  You could argue that their pricing was too keen.  But having said that, building societies generally are better capitalized than the banks.  But they cannot change their capital ratios so quickly.”


On the back of the Kent Reliance move, we are now again seeing the rise of those demutualization campaigners, with the Financial Times speculating how much building society members could gain if various societies are bought up by the Kent Reliance/JC Flowers joint venture.  It is not a pretty sight for anyone committed to mutuality.


This is not the first time that Kent Reliance has acted controversially.  Chief executive Mike Lazenby – formerly director of marketing for the Nationwide – has made his society one of the most cost efficient operators in the sector.  He has done so by closing most of the society’s branches and transferring back office functions to its wholly-owned subsidiary Easiprocess in India.


Yet Kent Reliance is now under some trading pressures, which the injection of capital will assist with.  In a statement, the society said: “If the new structure proceeds, it would allow for substantial new capital investment to support the business and would provide a means for the society’s members to remain members of a mutual organisation.”  We asked the society for clarification on whether the changes would be an effective demutualization, but a spokesman said: “Legally we are not allowed to comment further.”


As with the rest of the building society movement, Kent Reliance is doing less well than in the past.  Net profit for 2009 was significantly down on previous years: £1.7m, compared to £9m in 2008.  That did not prevent the chief executive’s remuneration being higher than that of some of its competitors.  Lazenby was paid £535k for 2009, including pension contributions and a bonus related to the 2008 performance.  This was up from £481k on the year before. 


The £14k rise in Lazenby’s director’s pay, plus £15k increase in pension contribution, attracted criticism from some members.  It also put Lazenby on a higher remuneration package than Neville Richardson in the year that the Britannia Building Society merged into Co-operative Financial Services – despite both (even before merger) being very substantially larger than Kent Reliance.


JC Flowers is being given an opportunity to enter the banking market, after previous attempts failed: it is particularly keen to take over Northern Rock and might do so through the joint venture.  Kevin Mountford, a banking specialist at the comparison website, said: “Although the brand and products will be retained in the short term, Kent Reliance members should be cautious about this deal before they give it the green light. The intention of the new mutual to tie up with other smaller building societies will almost certainly lead to further consolidation in the market and, as we have seen with other mergers, the financial realities of these deals will no doubt lead to the loss of some names on the high street and job losses. However, for many of the smaller building societies, they have very little option as doing nothing would threaten their long term survival.


Co-operative law specialist Cliff Mills – who is an advisor to the Mutuo think-tank – is concerned.  “It seems to me to be very close to demutualisation – though not entirely because of the minority nature,” he says.  “However, it brings to mind the Irish milk business which went down this route and ended up fully privatised.”  Cliff adds that while he is unconvinced that it is legal and practical to transfer Kent Reliance to an industrial and provident society, he points out that the intention behind the Butterfill Act was to protect mutuals and, in doing so, it accepted a lower threshold for member approval in making the transfer than would be required for a demutualisation.


The BSA is very careful with its description of the Kent Reliance Building Society potential restructuring, but is clearly not advocating it as an approach that other societies should emulate.  Adrian Coles says: “The Kent Reliance is unusual in that it has been growing very rapidly in recent years.  In order to maintain that rate of growth it needs additional capital and this is one interesting way of doing that.  I think it’s unlikely to be a template for the sector.”


The Kent Reliance move should not, though, be seen in isolation: it has similarities with other moves around the world.  In France, the leading mutual banks – such as Credit Agricole – previously sold some of its equity and in Spain, the caja movement of trustee savings banks is being rescued with external capital that gives investors a half ownership of the institutions.


This may be a global phenomenon – but it is one that I view with trepidation.

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