Sir Christopher Kelly’s review into the crisis at The Co-operative Bank began in September. While that review is conducted in private, it is becoming clearer to outsiders what the review should consider. Much of that will overlap with the Treasury Select Committee’s enquiry into the collapse of the Project Verde deal, which has increasingly focused on the role of the Britannia Building Society acquisition in undermining the capital position of The Co-operative Bank.
We should remind ourselves that there were four central reasons for the capital hole in the Bank. Firstly, there were about £500m in write-downs out of the commercial property loan portfolio taken on from the Britannia. Secondly, more than £370m was set aside to compensate for the mis-selling of payment protection insurance – and the need to increase earlier provisions exacerbated other problems. The third issue on the Bank’s balance sheet was the need to write-off about £300m of existing IT investments.
But the capital adequacy issue was not just about the balance sheet figures. For one thing, the absolute failure of the Bank to have a coherent strategy on IT systems eventually led to the recognition that an additional £500m would have to be found for new investment. The other non-balance sheet factor was the ramping up by the regulator of the capital requirements for all banks.
There are several implications related to these facts that Kelly will surely be considering and investigating. Why has an ‘ethical bank’ mis-sold payment protection insurance? Did this reflect the need to cross-sell products from Co-operative Insurance Society? Come to that, why did Co-operative Financial Services continue with the so-called bancassurance model – having a combined bank and insurance business – some time after most of the financial services industry decided this was not a viable option?
Alternatively, if there had been a continued strategic rationale for retaining the bank and insurance link, why and when was this abandoned? Was this simply to accommodate the Britannia deal? Did it make sense to take on more mortgage lending in place of insurance? What impact did this have on the previous IT investments? How well thought out was the strategy to expand the branch presence at a time when the role of branches in banking is rapidly diminishing?
My concern here is the strategic failures. From the outside it feels as if the board were adopting a succession of different strategies, sometimes going for organic growth, at other times seeking acquisitions. At one point the idea was to use an IT strategy that enabled cross-selling of banking, insurance and consumer retail products, yet subsequently the insurance businesses were put up for sale as no longer being core. And the crisis has led to the enforced separation of the banking operation from the Group’s consumer retail business.
It could be argued – and I think it is an inference from former Bank CEO David Anderson’s evidence to the Treasury Select Committee – that the main cause for the crisis is actually strategic mis-management in the period following the Britannia acquisition and specifically the strategic change of direction regarding IT investment.
This should not lead us to ignore the issue of the write-downs on the commercial property portfolio. Evidence to the Treasury Select Committee from former Group and Bank executives, the Bank’s former chairman, its auditors KPMG and the Britannia deal advisors JP Morgan all basically point to the unexpectedly long duration of the ‘Great Recession’ as being the primary reason for defaults on the property loan book inherited from Britannia. None of the evidence has pointed the finger at the role of The Co-operative Bank in the way it conducted its own due diligence. (Although KPMG conducted due diligence on ten elements of the Britannia acquisition, they did not undertake the due diligence on the property loan book that eventually went bad.)
Yet the prospectus issued by The Co-operative Bank appears to suggest a more complex picture. This suggests that the former Britannia commercial loan book was over exposed to too few borrowers, operating in too few sectors. This clearly amplifies the risks associated with the loan book. So Kelly will need to know what consideration was given to this by the Bank and how and to what extent this was considered by the Group’s risk committee.
Indeed, I hope that Kelly will give significant consideration to the Group’s risk committee. Questions that need to be asked include its composition, whether there were conflicts of interest in it being chaired by an executive officer rather than a non-executive director and how carefully risks were evaluated and mitigated.
The issue of risk management should, anyway, have been at the heart of the decision-making of the Bank’s board. Yet, here too, there are doubts about how effectively this was taken into account.
A recent report by Fitch Ratings sheds some light on how a bank’s financial reports show a very restricted picture of the health of the institution. Fitch pointed out that regulators do not rely on the impairments on a bank’s balance sheet when assessing capital positions. Instead, regulators make more cautious assumptions on likely future impairments.
If regulators take a more cautious view of a bank’s account, this leads to three new questions for Kelly. One is whether senior managers of the Bank were aware of this revised approach being taken by regulators and whether they were drawing up alternative interpretations of the capital adequacy position in light of this. The second – assuming that executives were doing this – is whether they gave this fuller picture to the board.
But the third question is about the regulators – did they tell the Bank of the changes in how they assessed capital adequacy. Similarly, what warning did regulators give to The Co-operative Bank that they were going to adopt a tougher interpretation of capital adequacy requirements?
It would seem that regulators – at that time, the Financial Services Authority – may themselves have been caught unawares of the change. It may have been imposed at short notice by a change of policy by the Bank of England. This was especially difficult for The Co-operative Bank, given its lack of recourse to capital markets to plug a capital hole because of its mutual status. Nationwide has been able to avoid serious difficulties by having access to a capital instrument that is not available to the Co-operative because of its different legal structure.
Parallel to this regulatory challenge sits a telling issue – why was it another credit ratings agency, Moody’s, that was first to spot the hole at the heart of The Co-operative Bank? The Bank has yet to persuade observers that its full year accounts for 2012, published in March 2013, were as comprehensive and open as they might have been.
To the outside observer it appears that much of the crisis stems from varying examples of two specific problems. It seems that there was no consistency in the strategy for growth and the Bank appears to have rejected the use of cautious strategic financial management.
There is evidence to support these contentions. Even while The Co-operative Bank was negotiating with Lloyds to acquire the 630 branches under Project Verde, it was also seeking to expand through other mergers. As late as April 2012, the then Bank chairman, Paul Flowers, and its then chief executive, Barry Tootell, met with the chief executive and finance director of Northern Ireland’s largest building society, the Progressive. Two options were put on the table, one was the acquisition of the building society by the Bank and the other was a joint venture in which the Progressive would sell Co-operative financial products. The Progressive rejected the approach. I look forward to finding out how much information on this approach was given to the Bank’s board.
Even while the Co-operative was attempting to integrate with the Britannia – and before entering into the Project Verde negotiations – it was seeking other building society acquisitions. I understand negotiations were reasonably advanced with the Norwich and Peterborough Building Society, before the Co-op walked away from the table. The Co-op was also interested in making acquisitions in Scotland. The rationale was that even with the Britannia acquisition, the combined business remained too small to have the necessary scale to challenge the large retail banks.
I find the timing of these negotiations rather surprising, bearing in mind that Neville Richardson was warning that the Bank was having difficulty completing the integration with the Britannia. He was also very unhappy at the progress of Project Unity – bringing together the systems and branding of the Group’s retail business with the Bank. We – and Kelly – need to understand much more about the relationship between Richardson and Group CEO Peter Marks and which of them was the more dominant when it came to the key strategic decisions and recommendations.
There is also one other issue about Project Verde that needs to be examined, which surprisingly was not probed by the Treasury Select Committee. KPMG said that it had advised the Bank in April 2013 not to proceed further with Project Verde for four reasons. One of those was that integration of Lloyds with the Co-operative would be too difficult and another was that the Co-op would be dependent on Lloyds’ IT systems for ten years after the deal went through. I find it surprising that these issues only became evident at such a late stage – it might have been expected that if these were going to be deal breakers, they could have been determined very quickly.
In truth there is much that Sir Christopher will need to discover and reveal. Let’s look forward to the report in the Spring of next year.