Speculation has intensified over recent days about the future of the Co-operative Bank. According to the Times and the Sunday Times, the Bank may be forced to close, or sell its operations.
The spark for this latest bout of bad news has been a statement from the Bank about its capital position. At present the Bank meets the minimum capital target it set for itself – 10% common equity tier 1 (CET1) – an important measure of its financial strength and above the regulatory requirement of 6%.
However, the Bank expects to fall below this in the coming months. In a statement to investors, it said: “The Bank is updating its previous guidance and now expects its CET1 ratio will fall and remain below 10% over the medium term and that it is unlikely to meet its individual capital guidance over the planning period to 2020.”
Why has this happened?
There are several reasons for the deterioration in the Bank’s capital position. One is the low interest rate environment – the Bank of England has just confirmed the base rate will continue at 0.25%, providing limited opportunities for low risk profits for banks.
Meanwhile, the Bank continues to be hit by penalties for past mis-selling of payment protection insurance to customers, while its repair process involves ridding itself of some assets – damaging its capital position.
Negative media coverage is based on the expectation that the PRA will tell the Co-operative Bank that it must strengthen its capital position. It is unclear how the Bank would be able to do this.
The PRA did not respond to a request to comment, but other media has reported that it has declined to discuss the issue. Sources close to the Bank suggest that media reporting has been exaggerated and there is no serious difficulty facing the Bank regarding its capitalisation.
The Bank was rescued by hedge funds, which now own most of its equity. They probably assumed a good return on their investments, but given the current situation they may now be taking a less positive view. If so, they are likely to be reluctant to put more money in, if the PRA requires this. Moreover, one of the hedge funds that rescued the Bank – Perry Capital – is now in wind-down mode.
The Co-operative Group remains an owner of a minority stake in the Bank but it is difficult to imagine, given the ongoing rescue process at the Group, that there is any appetite to put its stretched capital into the Bank.
A spokesman for the Group said: “The Co-op Group notes the announcement from the Co-operative Bank and looks forward to working with the Bank on its plans.”
In fact, the Bank’s financial situation is continuing to put a strain on the Group’s profits. In its interim results statement for 2016, the Group announced it had written down the value of its stake in the Bank from £185m to £140m, generating a loss of £45m. This, said the Group in its accounts, is “consistent with falls in bank valuations generally”.
Fitch Ratings (one of the “Big Three credit rating agencies”) responded to the Bank’s announcement on its capital position with a detailed analysis. The Bank’s guidance, said Fitch, “highlights the difficulty of turning around troubled UK banks, particularly while interest rates remain low and the economic outlook remains uncertain”.
But Fitch recognised that the Co-op Bank faces specific challenges in its trading position. “Co-op Bank, in particular, is struggling to return to profitability as it is focusing on residential and buy-to-let mortgage lending, where yields are generally tight,” said Fitch.
“The base rate cut in August 2016 is likely to have hit the Bank’s revenue generation plans, as a large portion of its legacy loan book is sensitive to falling rates.
“At the same time, Co-op Bank is incurring high costs to enhance its systems and procedures to increase efficiency and improve risk controls.”
As a result of the latest capital statement by the Bank, Fitch agrees it is unlikely to meet its capital targets before 2020 – a year later than it previously expected. This hampers the restructuring, which would probably have also involved a change of branding away from (misleadingly) using the ‘Co-operative’ name.
Fitch Ratings continues: “Co-op Bank’s relaunch is crucial for it to become a viable business, but losses and capital erosion continue to hamper its progress. We expect Co-op Bank to report losses until at least 2017, and significant investment in new systems could extend losses into the medium term.
“Profitability should begin to benefit in 2018 when fair value adjustments related to the 2009 acquisition of Britannia Building Society are fully unwound.”
My guess is that the hedge funds will be feeling impatient with this thought and may have hoped for a faster return – and now fear they will get no return. Fitch Ratings is clear that profitability is only possible if the Bank can accelerate its restructuring process.
It says: “a return to structural profitability depends on Co-op Bank’s ability to generate new, better-quality and higher-yielding mortgage loans and to reduce operating costs, particularly through improved automation and digitalisation.”
What will happen next?
While parts of the media are speculating negatively about the Bank, Fitch is more constrained in its projections. It believes the Bank’s funding and liquidity positions “are relatively sound”, with funds available from customer deposits and access to additional sources of finance. The overall verdict of Fitch is not glowing, but could be worse.
“We believe the Bank will maintain sufficient capital to remain viable,” it said, “but its margin of safety is limited and a material weakening of the economic environment could lead us to question the viability of its business model.”
The markets appear more concerned. Following the Bank’s statement on its capital position, the value of some of its bonds fell by 30%. This reflects a growing fear that the bonds may end up completely written-off as part of a government rescue or other emergency restructuring. The next big deadline date is September, when the Bank is scheduled to repay a £400m bond.
These are big sums to raise for an institution that is the subject of such negative speculation in the national press. The 2014 rescue of the Bank involved the issuing of £400m of shares. Yet “The Bank’s CET1 fell by £455 million in 2015 alone,” reports Mark Taber of Fixed Income Investments in a note to investors.
Mr Taber continued: “I cannot see the PRA accepting any plan which does not generate at least £500m of additional CET1 in which case all sub-debt would have to be converted into equity. Even that looks a step too far considering the equity still is not listed and the Bank still is not in any shape to prepare a prospectus for an equity listing. So I am struggling to see any plan the Bank can come up with which the PRA will accept this time around.”
Perhaps it would be wrong to add to the speculation over the future of the Bank by discussing what would happen if it did collapse – but there will clearly be concerns. For the Group, the loss of a further £140m on its stake in the Bank would be painful, but not dangerous, given that it has a net asset position of around £3bn. However, £140m represents about six years’ Group profits on current performance levels.
For individual customers, they are protected by the Financial Services Compensation Scheme. This covers £85,000 protection per person on bank deposits – or more, in the case of short term deposits (for example, funds held in an account for a few days while a house is purchased).
The Co-operative Bank declined to comment. However, the Bank clearly regards the stories in The Times and the Sunday Times not just as unhelpful, but also misleading.