The near collapse of the Co-operative Bank in 2013 was the result of a variety of factors and failures. It was clearly in part caused by weak corporate governance at board level in both the Bank and its then owner, the Co-operative Group. Those weaknesses, in turn, reflected too much control and influence at executive level and too little challenge at board level.
But why did the regulators not prevent the crisis? Were they asleep at the wheel? That was the question posed by the Treasury when it asked a former senior Canadian banking regulator, Mark Zelmer, to conduct a review of the failure of the Co-operative Bank. Zelmer was asked to consider not only what the former Financial Services Authority (FSA) did wrong, but also what the replacement banking regulator, the Prudential Regulation Authority (PRA), and the Bank of England can learn from the debacle.
Zelmer’s report has now been published and while it does not seek to blame the FSA for the Co-op Bank’s crisis, he is clear that stronger action by the FSA should have been taken to identify the weakness of the Bank, to monitor its worsening financial situation and intervene over the merger with the Britannia Building Society, which was the main cause of the near collapse of the Bank. However, Zelmer believes the FSA was not mistaken in its decision to allow the Bank’s Project Verde bid for parts of the Lloyds Bank portfolio to proceed.
As far as the board of the Co-op Bank was concerned, the merger with Britannia was a great opportunity to widen the market in which the Bank operated – it created opportunities to cross-sell between the mortgages that Britannia focused on, as well as the banking and insurance products where the Bank was strong.
But the FSA as regulator had an entirely different perspective on the transaction.It regarded the Bank as conducting a rescue of Britannia, preventing it from folding.
The Bank’s directors were unaware of this perspective. Nor did the due diligence exercise conducted by the Bank give the board the necessary information on Britannia’s weakness. The poison in the mix was in the Britannia loan portfolio, which was not properly reviewed in the due diligence. It was that failure of due diligence that led to the Bank’s then chief financial officer Barry Tootell, who was subsequently promoted to chief executive, to be severely sanctioned. (Tootell was eventually fined £173,802 and banned from holding a senior position in an authorised financial institution.)
According to Zelmer, part of the reason for the FSA’s inadequate response to the Co-op Bank’s crisis – and specifically its failure to intervene in the right way in its merger with Britannia – was that the FSA was just too busy in 2009, the time of the merger. With a wide-ranging and systemic banking crisis swirling around it, the FSA did not have the capacity to address the specific problems of the Co-op. It seems it was just thankful that the problems of the Britannia were being resolved by its incorporation into the Bank.
The context, says Zelmer, was that “from 2008 to 2013, the FSA was busy fighting many fires on a number of fronts as it managed the failures and rescues of a large number of financial institutions in the very febrile economic environment that prevailed in the aftermath of the worst financial crisis of the post-war period.”
Zelmer explains that “the FSA was broadly aware of the prudential risks associated with Britannia assets when it approved the merger, but the FSA had to form a view on the Co-op Bank/Britannia merger in the context of unprecedented conditions that prevailed in the UK financial system.”
But it was not part of existing practice of the FSA to consider whether an acquiring bank conducted sufficient or appropriate due diligence on an acquisition target. “The FSA supervision team did not consider the completeness of the Co-op Bank’s due diligence work as part of its approval process because a detailed review of an acquiring firm’s due diligence was not standard procedure for supervisors at that time,” says Zelmer.
The report adds: “The FSA approved the merger because it saw it as desirable for both the Co-op Bank itself and banking competition more generally, as well as to contain the potential risk of a major loss of confidence in the building society sector that it judged might emerge in the event that Britannia failed. The FSA and the other Tripartite authorities (HM Treasury and Bank of England) viewed the Co-op Bank as the best available safe harbour … The FSA approved the merger in 2009 knowing that there would be vulnerabilities in the merged bank’s balance sheet and that there was a risk that the bank would need more capital in coming years.”
Zelmer continues: “In hindsight, challenge by the FSA supervision team of the Co-op Bank’s due diligence work might have been helpful in mitigating that bank management’s lack of risk management expertise and broader governance weaknesses.”
Another failure followed from the Britannia deal. The IT system that the Bank had previously procured was no longer suited to its operations, once the mortgage business was incorporated.
As a result, a very substantial procurement cost had to be written off. But the FSA did not pay sufficient attention to the impact of the accounting write-down on the value of the Bank’s balance sheet, nor on what it meant in terms of the Bank’s ability to cope with further write-offs as the Britannia loan portfolio began to crystallise large losses. Other large losses followed because of past mis-selling of payment protection insurance policies.
As the Bank struggled on, the FSA took insufficient interest in the Bank’s financial affairs. It underestimated the challenges the Bank would be faced with in terms of refinancing. In particular, it failed to take account that as a subsidiary of a mutual – the Co-op Group – the Bank could not raise new equity capital without demutualising. And the FSA took excessive regard of the clean audit from the Bank’s auditors, KPMG. (KPMG is expected in the next few days to be fined £4m by the accountancy regulator, the Financial Reporting Council, over its flawed audit of the Bank.)
Perhaps surprisingly, Zelmer is not critical of the FSA for permitting the enlarged but weakened Bank from bidding for the Project Verde assets of Lloyds Bank. However, he notes that while the FSA was concerned about the poor health of the Bank, HM Treasury was actively promoting the Bank’s acquisition of the Lloyds Bank portfolio of 632 branches in Project Verde. It would have been better, Zelmer suggests, if there had been better information sharing between two bodies which shared regulatory oversight of the banking sector.
That was then and this is now. The FSA has been abolished and the PRA takes a stronger approach, having recognised the things the FSA did wrong. But that is not to say that the near failure of the Co-op Bank might not be repeated with another institution. It could. Zelmer points out that things are getting better, but are not perfect. The PRA still needs to build greater capacity. And there remain, he suggests, particular challenges with smaller financial institutions. It is to be hoped, though, that we never see a repetition of something quite so bad as the near collapse of the Co-operative Bank.
Paul Gosling is author of The Fall of the Ethical Bank, published by the Co-operative Press