Co-op Bank downgrade

The Co-operative Bank has been downgraded by Moody’s credit ratings agency from A3 to Ba3 – in other words from being of good quality to being what is called ‘junk’. This sounds more serious than it is: there is no serious prospect of the bank being unable to meet its liabilities and it is shored up by the assets of the parent Co-operative Group. However, it is the most dramatic reduction in credit status of a respected bank that I can recall.

Moreover, the downgrade is very bad news for the bank and its reputation. On a practical level it makes it more expensive for the bank to borrow and the interest rates it charges to mortgage customers, for example, could rise, making it more difficult to win customers. Further, potential current account switchers could be put off by the negative publicity that has been generated across the national media.

The decision of Moody’s has little to do with the aborted acquisition of surplus Lloyds branches, but has a lot to do with the merger with Britannia, which is beginning to look like a very bad deal for the bank. However, even without the problems taken over from Britannia, the bank would have still have reported a net loss for last year because of an additional £150m provision for the mis-selling of payment protection insurance (PPI).

It is the issues with the Britannia’s loan book that is causing the big problems. Britannia was involved in activities that were not core to a building society and are not today regarded as core for the Co-operative Bank. These are mortgage lending to non-member, sub-prime, customers; loans for commercial real estate; and buy-to-let. All of these parts of the loan book have now been ‘impaired’. In lay language, the bank no longer expects to be fully repaid what it is owed.

All of these parts of the business are in the process of being closed or sold. So, too, will the loans to housing associations, which have not been impaired, but are not regarded as core to the bank’s activities. The housing association loan book, one would hope, will attract a ready buyer. Whether the impaired assets do we will have to wait to find out.

Moody’s disquiet seems in part to be because of delays in the Co-op recognising the scale of its problems. In the view of Moody’s, greater impairments should have been reported in the 2011 results, rather than waiting for 2012. Moody’s report stated: “Co-operative Bank posted a loss before taxes of £673.7 million in 2012 compared with a profit before tax of £54.2 million in 2011. The loss was mainly driven by a significant increase in impairment losses to £468.7 million (£114.9 million in 2011), close to four times the impairment losses recorded in 2011.” It is recognised within the bank that, in retrospect, it was slow in impairing parts of the loan book inherited from Britannia and, to a lesser extent, in its provisions for compensation for PPI mis-selling.

This raises important questions about the merger with Britannia – or what was, if we are honest about it, a nil cost acquisition of the society by the bank. It came with problem loan books and this will have been recognised when the audit firm KPMG examined the books prior to merger in what is technically called a ‘due diligence’ exercise. Due diligence is expected to highlight exactly these points and the bank continues to believe that it knew exactly what it was getting when it took over Britannia.

But the Co-op Bank was caught seriously by surprise by the scale and duration of the economic crisis. Even in 2011, the bank’s results reflected over-optimism in an economic recovery. Whether the bank would have been in a stronger position to predict economic trends if – like most of its competitors – it had a senior economist is another interesting question. But economists, too, often get it wrong.

Just as Moody’s is concerned at the worsened situation of the bank’s balance sheet, customers and observers will also be surprised at the succession of recent bad news events. When the results were announced there was an assurance that the Project Verde acquisition of surplus Lloyds branches would proceed. Then the Lloyds deal was dropped, but there was an assurance that the bank’s capital position was strong. Subsequently, Moody’s challenged the bank’s view of its capital position.

Capital adequacy is essential for a bank and regulators have responded to the global banking crisis by requiring higher levels of capital support for any bank. This in itself is a problem for a co-operative bank, building society or other financial mutual. Banks’ capital support usually comes by way of shareholder equity. As mutuals do not have shareholder equity, their capital support comes from reserves built up over a long period from profits.

Where a bank has insufficient capital it can launch a new share issue – as Deutsche Bank and many others are currently doing – or even by not paying out dividends to shareholders as cash, but instead by issuing them with additional shares – as Santander is doing. The lack of capital support is by no means restricted to the mutual sector, but is a much bigger problem for a financial mutual.

The bank has argued that its capital levels are healthy. (Banks must have a 7% capital adequacy ratio, which will go up to 9.6% when Basel III is implemented.) However, Moody’s is not persuaded by what the Co-op Bank has said.

Moody’s states: “The bank reported a Basel 2.5 Core Tier 1 ratio of 8.8% at end 2012 (which improved to 9.2% in January 2013 following a securitisation transaction), which is considerably lower than those of its UK peers. In addition, Co-operative Bank reported a fully-loaded Basel III CET1 ratio of 6.3% (which improved to 6.7% in January). This is already below the new target capital ratio of 7%.” It adds that the bank has a “weak loss-absorption capacity”.

Everyone accepts that the bank must now shore up its capital position, so the question is how to do this. The Financial Times has suggested that the bank needs to find an additional £1bn in capital. This was previously regarded by the bank as an over-the-top assessment – but that view should perhaps be reconsidered after the Moody’s verdict.

The first step in plugging the hole comes from the disposal of the life insurance business to Royal London. That has just been approved by the Royal London AGM and raises more than £200m. The general insurance business is up for sale and there are hopes this could generate £650m, with a bid of that amount from Aviva reportedly being considered by the Co-op. That leaves perhaps £150m or a bit more to find, some of which could be achieved from sales of the non-core Britannia loan portfolios.

Whether these disposals fully fund the capital requirements is impossible to judge without access to confidential papers, one of which is the capital action plan that has been submitted by the bank to the regulator. The bank believes the plan shows a fully funded resolution to its capital adequacy problems.

I understand that it has considered issuing permanent interest bearing shares (PIBS), which are a type of bond used by building societies to raise capital. But this is unlikely to be a solution as regulators are unlikely to accept these as the right type of loss-absorbing capital.

Moody’s report expresses doubt about whether the steps being taken are sufficient, given the difficulties in raising capital and what it predicts will be further impairments on past loans. It expects the Group to have to step in to improve the bank’s capital position. The alternative would be that the bank’s profits could generate sufficient capital to restore capital levels. But in a low interest rate environment, profits are difficult to generate from retail banking and it is not realistic to expect profits in the near term to do much, if anything, to assist with capital adequacy.

This picture is grim, but does not suggest a bank that is in danger. Speaking personally, I have what for me are significant sums of money spread across several Co-operative and Smile accounts – and I will not be moving them. I have absolute confidence that the bank will survive and continue.

But a few weeks ago, the BBC’s respected business editor Robert Peston said that the Co-operative Group, under its new chief executive Euan Sutherland, would be reviewing whether to maintain its banking operation. That suggestion today does not look as far-fetched as it did a fortnight ago. I am assured, though, that while Sutherland will conduct a comprehensive review of Group activities, this is not expected to question the bank’s continued operation.

That review could, though, suggest major reforms to the banking operations that prevent it producing losses in the future that wipe out the profits generated by other parts of the Group.

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