I was contacted recently by a close observer of the Co-operative Bank’s affairs, who suggested I had missed a dimension to the crisis at the Bank. Over the longer term, my contact argued, profits had just been too low. As a result of this suggestion, I have spent hours wading through the financial results not just of the Co-operative Bank, but also of several of its competitors.
In itself, this exercise has produced some interesting findings. Judging people with the benefit of hindsight is always unfair, of course, but here goes anyway. During the early period of the financial crisis, leaders of financial mutuals prided themselves that they were able to withstand the hostile commercial environment better than many PLCs.
So it is perhaps not surprising – though it is clear now that it was very wrong – that the then chief executive of the bank, David Anderson, should say in 2008: “Our business model and core co-operative values have limited our exposure to the market forces that are causing concerns for many of our competitors.”
At that point – prior to the Britannia merger – the 2008 report was able to state “the Bank has maintained a strong balance sheet position with consistent robust liquidity and capital ratios”.
Another comment from the same year can now in retrospect be regarded as even more horrifyingly misguided. “Co-operative Financial Services (CFS) started the journey in 2006 to better serve its 6 million customers through transforming its business and technology capabilities.
“CFS has commenced a substantial investment in new technology in 2008, via an Enterprise Platform Programme, to replace our retail and corporate banking system. The investment will allow CFS to re-engineer its customer facing and internal processes and will provide an opportunity for further integration of our Banking infrastructure with that of the Insurance businesses so that we can be truly customer centric in the way we sell to and serve our customer base. This investment supports our customer relationship strategy across Banking, Insurance and Investments to deliver attractive, fair, accessible products on a scaleable multi-channel basis.”
That reminds us that there were two underlying elements in the unravelling of the Bank, or of CFS as it then was. At that point – less than five years ago – the future of the business was still seen as combining banking and insurance, despite the rest of the industry moving away from that model. Investment decisions, such as the vast IT spend, were predicated on that strategy.
But we also know that the investment was apparently a waste of money. More than £300m has been written-off and an additional £500m will now be set aside to provide an effective IT system. That new system must not only service existing customers on their existing banking channels, but will also enable them to conduct their banking via smart phones, which is seen by the industry as probably the primary transaction channel for the future.
My attempt at analysing profits over several years was less successful than dredging up old, embarrassing, quotes. Certainly profits as a percentage of income seem very low for the industry – in most years it was 0.8%, or thereabouts. But comparing this with other financial services businesses is very difficult. There are inconsistencies in how income is reported between different types of provider and no other financial services provider has a strictly comparable business model.
My impression is that profits were probably around half the level that they should have been for this type and size of business. However, proper examination of the profits contained in the financial reports was perhaps overlooked by us commentators, who were just happy in those days that the financial services operation was recording profits. Credit ratings agencies probably also paid too little attention to the Bank’s financial reports – a process anyway made difficulty because the Bank’s reports were less transparent than they should have been.
A more useful exercise is perhaps examination of the bank’s cost income ratio. Here we have solid evidence to examine. All of the main commercial banks in the year 2012 had a cost income ratio of around 60%. For Lloyds, it was under 60%, HSBC a bit over that and Barclays a bit higher again. Even the trouble-hit RBS managed only just over 60%. A year later, its crisis hit Ulster Bank division reported a cost income ratio of 61% – which it said was far too high and has been a driver for a substantial branch closure programme.
The industry has been heavily focused in recent years on bringing down the cost income ratio. In 2008, the cost income ratio at Yorkshire Building Society was 73%, but more recently it has been pulled down to one of the lowest in the sector, at 54%. Meanwhile, the Nationwide has cut its cost-income ratio to its best ever level of 54.8% in 2013.
So how does the Co-operative Bank compare? Badly, in simple terms. In 2011 the cost income ratio was 66%, then in 2012 it rose to 74% and in 2013 it hit 85%.
Northern Rock was the pioneer in low cost to income ratios – its collapse came about from low margins and dependency on wholesale markets, which seized in the early days of the credit crunch, not because of its drive to cut costs. Northern Rock’s cost income ratio was a bit above 30%, at a time when the industry standard was about 40%.
So, we can see that the Co-operative Bank is probably about twice where it should be in terms of its costs when compared to income. (Profit is not everything, but without sufficient profit to build reserves and allocate investment a bank is basically stuffed.) Even allowing for the skewing effect of the Great Recession, the Bank’s cost income ratio is about 25% to 30% above where it should be, if we take the Nationwide and the big clearing banks as benchmarks.
How do we get to where we should be? Well, to be blunt, we should not be starting from here. The fact that we are demonstrates a couple of simple facts. One is that senior management and the board allowed costs to be too high against income for a long period and chose to overlook the fact that profit levels were significantly below where they should have been. That is another example of long term strategic failure at the Bank (and Group).
That reality feeds into today’s situation, where without generating healthy profits in most years, there is no way to rebuild capital without demutualisation.
Inevitably today there are two essentials to move to a better cost to income ratio – and both are painful. There will have to be a substantial branch closure programme – which raises the question about why the rationalisation of branches following the Britannia acquisition has taken so long. It would seem that there has been procrastination that has exacerbated the crisis at the Bank.
The other factor needed to improve the cost to income ratio is a better IT system – but that is a problem that will cost £500m or so to put right.
Given the scale of this challenge it is possible to get, perhaps, a sense of why the board in recent years went behind Project Verde as a simple solution to a difficult problem. It offered a chunk of capital as part of the deal, potentially enabling the Bank to deal with its capital shortfall. It came with its own IT system, dealing with that challenge. And with the large number of new customers (at least initially and assuming they did not all quickly opt back to Lloyds) it offered the prospect of a change in the cost to income ratio.
But there were always two very big problems with Verde. Firstly, the scale of the acquisition in effect meant the Bank itself was being bet on the success of the deal. (Little did we know that the smaller Britannia deal had already made that wager, in fact.) Secondly, the deal would have delivered a large branch network which that also be an expensive overhead and which in the medium term would prove largely irrelevant to how most banking services will be delivered.
Modern banking is already being delivered by smart phone, with perhaps half of branches facing closure. In many instances the branches are being replaced by small kiosks in shopping centres. Banks that depend on customers self-servicing through smart phones and multimedia kiosks will be able to offer very low cost to income ratios. Those that do not will not be competitive.
My informant, it seems, is absolutely right, even if the profit figures in themselves fail to demonstrate that. Costs were simply too high for a business of this size. Opportunities to reduce the cost of the branch network were addressed too slowly. The wrong IT system was acquired, because the wrong business model was adopted, creating a massive investment error.
It is tempting to see the Bank’s crisis as the result of the infection in the Britannia which then spread across the body politic of the merged business. That explanation is too simple. A potentially fatal infection was already gnawing away at the business – lack of profitability.