Where The Co-operative Bank leads, the Nationwide Building Society follows. That at least seems to be the sad position regarding capital holes. Both have announced clear routes out of their problems.
The Co-operative Bank will be partially demutualised in order to save it. At present the Bank is a PLC wholly owned by the Group. In fact, this has led some commentators to argue that, strictly speaking, the Bank has never been a mutual, merely an asset owned by a mutual.
In future, the Bank will be majority owned by the Group, but with a minority of the equity owned by shares tradable on the London Stock Exchange. This is the basis of a debt for equity swap and provides an opportunity for the Bank to raise equity in the future, should it so wish, or if the situation dictates.
The Group has agreed with the regulator, the Prudential Regulation Authority, that it requires an additional £1.5bn of ‘at risk’ capital. This will be achieved by bondholders becoming shareholders.
Those bondholders affected are not people holding ordinary retail savings bonds, but rather holders of Permanent Interest Bearing Shares issued by the former Britannia Building Society and the subordinate bonds issued by The Co-operative Bank.
The other elements of the recapitalisation of the Bank are an additional capital investment by the Group and the proceeds of the life insurance business sale to Royal London along with the future sale of the general insurance operation, which is currently on the market.
Although this is a crisis for the Bank and the Group, the situation is a long way from being unique. Banks in Ireland, Spain, Greece, Cyprus and the United States have all had to deal with a shortage of capital to absorb losses – but regulators have been inconsistent in their approaches.
In Ireland, the Government made what now seems to have been a foolhardy guarantee of all retail deposits. It was like a wager on a weak hand in a game of poker. Global investors did not blink and the bet in effect pulled the Irish government into insolvency. In order not to spook the markets, the Irish government was pushed by other European governments and the European Central Bank into protecting senior bondholders from absorbing the banks’ losses.
By contrast in Greece, bondholders took a massive loss as part of the recapitalisation of the banks – they were ‘bailed in’, to use the jargon. In Cyprus, bondholders and savers with large deposits all lost out.
Whether the right balance has been reached with the Co-op on the split in losses between bondholders and the Group is a matter of opinion – but it is the regulator’s opinion that is the most important.
The Financial Times is unhappy with the division of pain. “The salutary lessons are that the UK would be safer with banks greater in number and smaller in size; and that bondholders can be ‘bailed in’ in an orderly fashion,” said an FT editorial.
“It is, however, a mystery how the Prudential Regulation Authority could sign off on a restructuring that seems to upend the established ranking of investors,” it continued. “In a resolution, shareholders should be fully wiped out before preference shares and bonds lose out. Here the shareholder – the Co-operative Group – is to retain control despite offloading some losses on creditors.”
This view is strongly refuted by the Group, which points to the extent to which it is investing additional capital in the Bank, including by raising £1bn in a new bond issue. “Equity shareholders are first in taking the hit,” said a spokesman for the Group. “The Group’s equity has been wiped out.”
Details on the level of loss to be faced by bondholders are now being worked out and will not be disclosed until October. Speculation on the scale of bondholders’ losses varies between a 30% and a 70% hit and bondholders are expected to be issued with a mix of new bonds as well as shares to replace existing bonds. More than 7,000 institutional and individual shareholders will be affected, including some co-operative retail societies and other co-operative organisations.
Nationwide believes it has a more comfortable route out of difficulty. The PRA has been undertaking a wide ranging exercise to assess capital strength amongst UK financial institutions. This was expected to show the Nationwide in a strong position. But it did not. According to the PRA, Nationwide has a capital shortfall of about £400m. According to the FT, the figure could be even higher and calculated it as a possible £1bn capital gap – a figure dismissed by Nationwide.
According to Nationwide, it is being penalised by the PRA for having done what the regulator’s parent, the Bank of England, asked it to do by increasing lending. While the Co-op, RBS, Lloyds and Santander all reduced net lending in recent months, Nationwide increased its – helping to refloat the housing industry. This, says the society, is one reason why it is now being shown as undercapitalised.
The other reason, says Nationwide, is that the PRA is using the wrong measure and one that discriminates against low risk lending by building societies. It argues that assessed by its low use of wholesale markets and high level of security in residential mortgage lending, it is much less exposed to market problems than are the big banks. In any case, says Nationwide, it is so profitable that it has generated £700m in the last three years and will be able to improve its capital adequacy through retained earnings within a timeframe that is acceptable to the PRA.
Both the Nationwide and the Co-op have suffered the same impediment – lack of access to market mechanisms to raise risk absorbing capital. In other words, they did not raise equity capital on the markets because they are mutuals.
This is an issue that has been of concern to the movement in the UK and internationally for many years. We all knew that this moment could happen, but carried on hoping that it would not.
The Nationwide went as far last year to obtain agreement from its members for approval to issue Core Capital Deferred Shares, which would be recognised as debt rather than equity, yet would satisfy regulators as being capital at risk. These will be recognised as core tier 1 capital for a building society. Nationwide is considering issuing a small first tranche of CCDSs to test the market, while insisting that it does not need to in order to meet its capital requirements.
There are a number of examples of compromises across Europe in terms of mutual ownership arrangements of co-operative banks. Although France’s fifth largest bank Crédit Mutuel remains a mutual, it has a subsidiary, CIC, which is listed on the Paris stock exchange. Crédit Agricole, another large French bank, has also listed part of its group in order to finance expansion and cover substantial losses from investment banking. Austria’s third largest bank, Raiffeisen Bank International, used a stock market listing for part of its group to cover losses on operations in East Europe.
If there were a simple way of raising at risk capital for a co-operative bank (or any other co-operative business) that does not jeopardise its mutuality then the best brains of the movement would have found it before now. As a result, we seem to be left with an uncomfortable choice of either compromising co-operative principles, or taking a more risk averse approach to managing banks and building societies – which means, in particular, limiting ambitions. It is not only an uncomfortable choice: it is, though, one that we must face up to.