To find the real story about the West Bromwich Building Society’s financial health you must read a fair way down into its statement explaining its latest annual results, which have just been announced. Pass over the stuff on increased savings, higher capital ratios and reduced reliance on wholesale funding.
The relevant content is the £65m provision for potential bad debts and an £11m write-down on property. The result – when combined with a sharp and expensive increase in payments towards the Financial Services Compensation Scheme – is a post-tax loss of over £39m for the year ended March 2009. A year before, the society had recorded a profit of £33m.
In his review of the year, chief executive Robert Sharpe reported that the losses related to a significant extent to its commercial loan portfolio – a market it has now withdrawn from. The society’s high exposure to buy-to-let lending has not led to a big impact on the society’s results. While this was reported as good news, if this market further deteriorates there could be more pain to come.
“During the course of 2008/09, the Group refocused strategically and returned to the core traditional activities of a building society,” said Sharpe, including funding lending from retail savings, reducing the use of wholesale markets.
By then, though, it was too late to put right problems that caused the society to fail the ‘stress test’ imposed upon it by the Financial Services Authority. The society’s ‘tier one capital’ was insufficient to cope with losses that were possible, if not (necessarily) very likely.
This an area of weakness for building societies and other mutuals. For a mutual financial services organisation, the only form of capital that is recognised as ‘tier one’ is retained profits. All other capital is borrowed, either from savers or the markets.
Share-issuing companies are in a different position. If their tier one capital is inadequate they can issue more shares, obtain more capital and overcome regulators’ concerns about their ‘capital adequacy’. The only comparable step that a mutual could do – until now – was to demutualise, or to be bought up.
This is exactly why the Dunfermline Building Society went to the wall. Without the option of seeking share capital, there was no alternative that allowed it to maintain its mutuality and raise capital.
Since then, the Treasury and the Financial Services Authority have been busy, anticipating the reality that other building societies could hit similar difficulties to the Dunfermline. I like to think that, in doing so, the Government and the FSA were influenced by the strong lobby by sympathetic members of the Treasury select committee and other MPs (including Co-op Party members) to protect mutuals in the financial services sector.
Consequently the FSA published an alternative model to raise capital for mutuals that would satisfy the test of being classed as tier one. The FSA announced last month the creation of a new form of capital – PPDS, or Profit Participating Deferred Shares. Existing investors holding tier two capital will be offered the opportunity to convert this into PPDS. On the same day that the FSA announced this option, the West Brom took advantage of it.
For investors, the benefits of holding PPDS is that they will hope for a higher return. There is also a greater probability of getting all their money out, as the alternative is that a society might not be able to continue trading independently.
But there will be fears that the issuing of a new class of share for building societies could be a slippery slope towards demutualisation. There has been a contentious debate for many years within the co-operative and wider mutual movement about whether risk capital can be attracted in ways that do not undermine the principle of mutuality.
The Building Societies Association says it has no worries about this. Rachel Le Brocq of the BSA says: “It is useful to have this additional form of capital available to societies. We welcome the [Financial Services] Authority’s vote of confidence in the building societies’ sector, evident from releasing this additional form of capital.
“We don’t think it compromises mutual status. It is still one member, one vote. You could argue there is a slight compromise: some members could end up with a larger share of the profits.”
But the biggest concern for the overall health of the sector is what the crisis afflicting West Bromwich, Dunfermline and others means for the future of financial mutuals. There are a variety of causes for the mess they have got themselves into. At the top of these is that they over-invested in speculative assets at the top of the market. This also raises questions about the quality of some societies’ decision-making processes and corporate governance.
It also, though, suggests that mutuals may not be retaining sufficient levels of profits to see them through the bad times. For building societies to build-up higher levels of reserves they will have to operate on larger margins.
Consequently, there is a risk that building societies could become significantly less competitive in the next period than they have been in the past – at least until they have built-up larger buffers of retained surpluses. And as they build-up larger reserves they risk again being targeted by carpetbaggers.
There are already signs of building societies losing their competitive edge, especially as they suffer badly from the system of contributing towards the Financial Services Compensation Scheme – which is proportionate to the amount of savings they hold, rather than their risk profile.
After years in which building societies dominated the mortgage best buy charts, the banks have become more competitive. HSBC, in particular, is trying to poach more customers, while a quick glance at the best buy tables as I write this shows that the Bank of Ireland (via the Post Office brand), NatWest and Clydesdale, as well as HSBC, all appear above even the best of the building societies.
The recession is not merely forcing some of the weakest mutuals to close. It is also forcing many different types of business models to be rethought, including that of building societies. This is a recession that could have very long term repercussions for the mutual sector.