The building society sector is in surprisingly good health, according to the just published KPMG Building Society Database 2014. Of the remaining 45 building societies, 35 have reported increased profits over the previous year, while reserves across the societies have risen to £13.7bn – an all time high.
It would be expected that the low interest rate environment would cause pressure on building societies’ margins and profits – as is generally the case in the financial services industry. Yet building societies have collectively recorded a new post-crisis peak in average net interest margin at 1.42%, the highest since 2005. Nationwide today dominates the building society sector, with 62% of its assets. But even if the Nationwide is taken out of the picture, the sector’s situation is strong. The other 44 societies together increased total assets by £3.8bn, or 3.1%.
This positive situation reflects more than just strength amongst the surviving building societies: it also suggests that they are focusing on their core operations. Moreover, many societies are in a better position than some of the banks to maintain mortgage lending. Building societies loaned slightly over a quarter of all mortgage lending over the last year, together lending some £44.2bn. Lending by societies away from their core residential property market has declined, with a fall in loans outstanding on commercial properties.
KPMG notes that building societies are unlikely to be particularly affected by some of the profound changes taking place in the banking market. There is growing competition to the big banks from new ‘challenger’ banks, including Virgin Money, TSB, Aldermore, Tesco, Sainsbury and Marks & Spencer. These entrants are unlikely to take mortgage lending market share from the building societies and some of the challenger banks appear to have little interest in moving into this market.
New competition to the traditional banks also comes from peer-to-peer lending and crowdfunding. As KPMG notes, these market niches seem unlikely to affect mortgage lending, at least in the near term.
Despite this positive environment, there are specific problems afflicting building societies. One is the difficulty in raising capital. This has been addressed – as discussed in my last column – by the Nationwide issuing Core Capital Deferred Shares. (CCDSs constitute risk capital that is potentially written-off if the institution hits crisis and will not convert to equity. This is contrary to the explanation in the last column, as a result of my own editing error. Apologies for this.) However, as KPMG – and the last column – explain, CCDSs are unlikely to be a solution for smaller building societies.
As capital requirements on all lenders continue to increase in future years, this will probably cause new difficulties for financial mutuals. Simon Walker, a financial services partner at KPMG comments: “Rising capital hurdles are likely to limit mid-term ability to grow until a cost effective route is found for societies to go to market and raise capital.”
There is a second problem identified in KPMG’s database report, which has been referred to on several occasions in the past. The building societies business model is essentially more solid and sustainable than that of banks because it uses savings from societies’ own members. This avoids dependence on the wholesale markets – it was the drying-up of these markets that caused the collapse of Northern Rock. Yet the Financial Services Compensation Scheme imposes a levy on financial institutions that is a percentage of savers’ deposits, rather than according to an institution’s
risk profile. This specifically discriminates against building societies, even though their business model is a safer one.
The KPMG Database points out the unfairness of this. So, too, does the manifesto for the next government just launched jointly by the Building Societies Association and the Association of Financial Mutuals. The manifesto notes: “The Financial Services Compensation Scheme (FSCS) is vital in protecting consumer deposits. The current funding model means that building societies pay proportionately far more in relation to their total balance sheets than banks. Societies are currently paying up to 16% of their pre-tax profits to FSCS. The unfair structure of the FSCS funding system needs to be urgently reviewed.”
This is not the only complaint made in the manifesto, with a plea to undo the unintended discrimination that is hitting financial mutuals. A consistent observation in the manifesto is that regulators are adopting a ‘one size fits all approach’. Indeed I observed this personally in Derry, where the local society had to be merged into a larger society because of onerous and expensive governance obligations – even though the society was viable, sustainable and very well managed. In another well rehearsed plea, the manifesto seeks other ways for financial mutuals to raise capital that meets the needs of regulators.
At the heart of these complaints lies the practical and philosophical question of whether mutuals deserve to be regulated in a different way from PLCs. This point is addressed in the mutuals’ manifesto. It argues that regulators should be given an additional core objective of ensuring a competitive financial market in which there is greater market diversity, including through financial mutuals being better able to compete with PLCs.
“The financial services sector in the UK is critical to our economy, but a few years ago it nearly bankrupted our nation,” points out the manifesto. “The business practices of a few plc banks were largely to blame. The necessary reform programme is ongoing to restore confidence in the whole financial services sector. The Government’s main approach has been through increasing regulation. But many politicians also recognise that having a more diverse range of firms in the financial services sector delivers a better deal for consumers and a more sustainable and resilient financial system.”
However, my own view is that while mutuals need a different regulatory system, this should be based on a more appropriate model rather than a less rigorous approach. Some building societies adopted flawed business models in which too much lending was made available away from the core activities of residential mortgages. The Britannia and the West Bromwich societies spring to mind. Meanwhile, another credit union has just collapsed.
Let us therefore agree that a different model of regulation of financial mutuals is required. But it is surely up to our movement ourselves to come up with a regulatory structure for financial mutuals that is fit for purpose. I suggest that so far we have failed to produce this.