On this day 12 months ago, a downgrade by ratings agency Moodys started a process that led to the end of full co-operative ownership of the Co-operative Bank. It wasn’t the only mutual bank by any means, but to look beyond the story of the year that followed, it is helpful to look back.
What role do mutuals play in banking? Well, a mutual savings bank is a bank which takes savings deposits from its members, who are also the owners and makes loans, sometimes to members only, and sometimes also to non-savers, who may then become members and owners.The loans are commonly to households, but in some cases may be to small businesses (and in turn, in some cases, those businesses, such as farmers, may be the member owners).
A history of mutual banking
They are commonly retail banks, funded by retail deposits collected through branches, rather than larger wholesale deposits from other banks or businesses through the money markets, including the ‘interbank’ market. Typically, in aggregate, small local retail savings banks collect more deposits than they can lend and they are net lenders to larger commercial banks.
Examples include the US savings and loan associations; UK building societies; credit unions; co-operative banks in Germany (Völksbanken), and elsewhere; agricultural co-operative banks such as the ‘Norinchukin’ in Japan and the network of agricultural co-operative banks that existed in France, prior to their amalgamation into Credit Agricole, the world’s largest co-operative bank. In the Netherlands, Rabobank was built by amalgamating smaller agricultural finance co-ops, while Raiffeisen banks in Austria and Germany, which were early co-operative banks or credit unions, started lending to small farmers in the mid-19th century and more recently amalgamated, in Austria, to form the Raiffeisen Bank (Group), which now lends to SMEs and larger firms and developed a strong branch network in Central and Eastern Europe post 1990.
Mutual savings banks are related to a range of other socially-oriented savings banks, including national post office savings banks and municipal banks, such as the Spärkassen in Germany or, Caja, or Caixa, in Spain. City based UK municipal banks, such as the Birmingham Municipal Bank, were absorbed into the trustee savings bank network along with former local trustee savings banks regulated by the Treasury and then amalgamated into a single bank, the TSB. This was taken over by Lloyds Bank to form ‘Lloyds TSB’ in 1995.
The new TSB was re-launched in September 2013 as a spin-off from Lloyds TSB (renamed Lloyds Bank) of 632 branches that were required by the European Commission’s competition directorate to be sold as quid pro quo receiving ‘state aid’ from the UK government at the taxpayers’ expense as part of bail-out of Lloyds Banking Group in October 2008. This was made necessary by the 2007-9 financial crisis following Lloyds TSB’s merger with the troubled HBOS, which was waived through by the government despite misgivings by the UK competition authorities in January 2009.
The new TSB is to be divested by Lloyds through an IPO (initial public offering of shares on the stock exchange) in 2014. It is intended to be a retail oriented ‘challenger bank’ to the big five high street banks (Lloyds, RBS – incorporating NatWest, HSBC, Barclays and Santander) and is no longer a true trustee savings bank – just as, in insurance, the Old Mutual is no longer a mutual.
There is one genuine trustee savings bank left in the UK, which is the Airdrie Savings Bank. The story of savings banks began at the turn of the 19th century when Henry Duncan became minister of Ruthwell, a small village on the edge of the Solway Firth in South West Scotland. In 1810 he decided to set up a parish bank. Duncan had the right skills, as he had spent three years working in a bank in Liverpool before becoming a minister. The idea was simple. People could open a savings account with just six pence.
The business model was easy to copy and within five years of the first bank opening, there were many more savings banks throughout the United Kingdom, then spreading around the world. Though, as Johnston Birchall observed: “Unfortunately, they had a flaw; they were not really owned by anyone, but administered as trusts by whoever could get their hands on them.” The co-operative and mutual model in turn offered a remedy, through membership and board election, although this was reversed in the late 20th century with a wave of ‘demutualisations’.
The first building society
The first building society in the world was formed by a group of labourers in 1775 in Birmingham, said to be Irish workers, from out of town and probably charged rent that was over the odds for living in the city. Co-operatives UK’s secretary general Ed Mayo tells the tale: “They were meeting in a pub, the Golden Cross Inn, now pulled down, when the landlord Richard Ketley put down a jar that was empty, not full of beer and set a challenge. Each person was to put in a coin and repeat the same on a weekly basis until the jar was full and they drew lots to see who would use the money to buy materials to build their own house. They all continued to fill the jar over the months that followed until all 20 people had completed their turn and built their own home.”
The first mutual was therefore established in the year before Adam Smith published his celebrated book on market economies, The Wealth of Nations, in 1776. Later in time, the idea came of a permanent building society, such as the Southern Co-operative Permanent Building Society, established a century later, which became the Nationwide Building Society in 1970.
Santander has achieved critical mass by absorbing former building societies starting with the second largest at the time, Abbey National, which was the second largest when it became the first to demutualise in 1986 following the enabling Building Societies Act passed in 1986. It then added the Alliance and Leicester, previously associated with the Post Office Savings Bank and the Girobank, and then Bradford and Bingley, which had demutualised in 2000, during the crisis, once cleansed of its problem loans (absorbed by UK Financial Investments (UKFI), which also holds the government shares in Lloyds (43.5% reduced by 6% or so following a relatively successful sale of shares in December 2013) and RBS (82%).
UKFI was originally set up hold the shares in the demutualised building society, Northern Rock, which had suffered a ‘run’ on the 14th September 2007 and had had to be all but nationalised in February 2008. The shares in the ‘good bank’ UKFI created from the wreckage were been sold, at a loss to the taxpayer, to Virgin Money in November 2011. The UKFI continues to run down assets of the ‘bad bank’ it also created.
Another building society, Cheltenham and Gloucester, whose name is no longer used, was demutualised in 1995 and subsequently taken over by Lloyds TSB. Halifax, which was by some margin the largest building society demutualised in 1997 to become a ‘mortgage bank’, merged with the Bank of Scotland in 2001 to form HBOS.
Finally, the membership of Britannia, which had remained a mutual, voted in April 2009 to merge with the Co-operative Bank (plc), to form a ‘super-mutual’ with a substantially increased branch network. The merger did not play out well, though. The Co-operative Bank failed in its attempt to purchase the 631 Lloyds TSB branches (and thereby to become a more significant ‘challenger bank’), despite apparent government encouragement.
A £1.5bn capital shortfall was then identified in June 2013 by the Prudential Regulation Authority, which had taken over the regulation of all deposit taking institutions (banks, building societies and credit unions) from the Financial Services Authority in April 2013. The causes of the capital shortfall have been analysed recently in an independent review, commissioned by the Co-operative Bank together with the Co-operative Group, led by Sir Christopher Kelly.
A core element of the regulatory policy agenda after the financial crisis has been to raise capital requirements on banks. Although, with very few exceptions worldwide, mutual savings banks were not implicated in the kind of financial trading that led to the crisis, the response by regulators treated all banks as if they were the same. Many had, however, become over exposed to weakening housing and wider property markets, given the nature of their business, particularly the caja in Spain. This put pressure on mutual savings banks.
The challenge they faced is that they cannot directly issue equity (shares) to outside investors to raise capital because they are owned by insiders (depositors and savers) and borrowers, in the case of mutual building societies. It is not that mutual savings banks can’t build capital. It is just that they have to do it patiently. Beyond raising more capital from members, there is no short cut.
Following the 1986 Building Societies Act, UK building societies were allowed to issue hybrid debt-equity capital instruments, that qualified as ‘Tier 2’ capital under the ‘Basel Accord’, in the form of Permanent Interest Bearing Shares (‘Pibs’), but restricted to raising no more than 50% of deposits from non-members via the wholesale money markets. Pibs were essentially ‘preference shares’, a type of debt instrument or bond.
Since the 2007-9 financial crisis, the internationally agreed ‘Basel Committee’ risk-weighted capital adequacy requirements have been raised and additionally, more ‘core’ equity (primarily ‘ordinary shares’ and retained profits) is required to be held along with near-equity ‘Tier 1’ assets, whilst Tier 2 requirements have been downgraded. This could present a problem for mutual banks because they cannot issue ordinary shares. Retained ‘profits’, or surpluses, for they are not ‘not-for-profit’ organisations, are their major source of core capital; which is essentially raised from profits not distributed to member-owners.
However, first Rabobank, in September 2012, and then Nationwide, in November 2013, have designed and issued quasi-equity (Tier 1) capital instruments to the satisfaction of regulators and have found strong institutional investor demand for them. For Nationwide, this instrument included a number of key mutual safeguards, including: one member, one vote; capped distribution; and no interest in any proceeds from demutualisation.
The Co-operative Bank
Within this banking ‘landscape’, where did the Co-operative Bank fit? It was not a primary mutual, in the sense of being owned directly by its depositors and borrowers. Indeed, it was structured as a shareholder owned company, which is not typical for a mutual, though also not unknown. Its shares were, however, held by the Co-operative Group, which is a mutual, owned by its members; that included other consumer societies, retail shoppers who receive dividends and, latterly, bank customers. It was therefore a co-operative by extension. At the outset of the 2007-8 crisis, it had a small bad loan portfolio with virtually none of it in the problem commercial property sector that continues to plague RBS and into which the UK mortgage banks and Spanish caja had strayed, and which had damaged Lloyds TSB via its takeover of HBOS. It was the merger with Britannia in April 2009 that led it into trouble.
The Co-operative Bank’s distinctiveness derived from its policy of ‘ethical banking’, adopted in 1992. This included customers attracted by its Smile on-line banking services. It also catered for organisations that aligned with that policy, such as charities and trade unions and clubs. However, over time, other specialist banks have emerged to serve these, such as the Charity Bank from 2002 and the Birmingham based Unity Trust Bank established in 1984 as a jointly owned venture by trade unions and the Co-operative Bank, holding an ownership stake of around 27%. The Co-operative Bank announced plans in 2014 to sell its entire stake to raise much needed cash.
Unity Trust operates a modest credit union development fund, a great example of social banking in action, so it is hoped that the new owners of these shares are sympathetic with its social objectives. The Co-operative Bank has also had a healthy market share with local authorities. A number chased higher returns from deposits in IceSave, an Icelandic bank, and got their fingers burnt in the 2008 Icelandic banking crisis. A number returned to the good old Co-operative Bank, but following its recapitalisation in late 2013, some may move on again.
It should be noted there are other ‘ethical banks’, including the Ecology Building Society, founded in 1981, Triodos, which arrived in the UK after a merger in 1994 with the mutual, Mercury Provident, and specialises in ‘green investment’, but is less geared up to provide full service current account banks, and the Birmingham based Islamic Bank of Britain, which does not invest in businesses that are ‘Haram’ (outlawed by the ‘Sharia’, or Muslim Scriptures). This can provide mortgages and savings accounts, but does not engage in full interest bearing current account banking and interest based lending, because the paying and charging of interest is not ‘Sharia compliant’.
The Co-operative Bank didn’t ‘fail’ because it was a co-operative, but because it was a bank – in a similar way to other banks in the UK, and elsewhere. The forensic report by Sir Christopher Kelly, released in late April, catalogued a woeful list of fundamental weaknesses. Perhaps not surprisingly, even if painful for those who hoped that the Co-operative Bank would be different, the troubles that affected other banks came into play – in particular, a failure to establish adequate internal risk controls and a failure of corporate governance in terms of its responsibility to assure that banking activities were properly managed by its executive officers and overseen by an effective board of directors.
While a number of other banks failed, though, the Co-operative Bank has not yet had to be bailed out by taxpayers. It avoided insolvency. In some ways, if the Co-operative Bank had not been backed by a co-operative, keen to find a shared and fair solution among the new owners, the outcome could have been much worse. With the Co-operative Group standing behind it, a deal was reached in late 2013 to limit the liabilities all round and to list the Co-operative Bank under a new ‘private’ ownership structure, albeit with co-operative values embedded in the constitution, on the stock exchange.
The Co-operative Group was left with a 30% shareholding, although with a new call for capital in March 2014 and trouble in the wider business, it may well not retain this level. As the Bank’s chief executive Niall Booker commented” “The Bank ended a very difficult year with stable liquidity and an improved capital position which we aim to strengthen further through our forthcoming capital raise. Over the past ten months we have also made significant progress in reforming how the Bank is governed and managed… There is further work to be done but customers should be in no doubt of our commitment to return to our roots as a smaller, efficient bank focused on serving individuals and small and medium sized businesses with values and ethics at our heart.”
This is the first in a series of six weekly essays that explores the future of co-operative and mutual banking. In future pieces I will turn to the mortgage market and the role of mutual banks in recent years, before moving to a series of key questions and opportunities for the future of co-operative and mutual banking in the UK. Mutuality has long been a force in banking, and indeed insurance. Its role has been to make markets work better for all. A diversity of providers is beneficial for consumers. Harnessing the potential of mutual banks is not something to leave to the market. Like the very first mutual savings banks, it takes vision and a willingness by like-minded communities to organise.
• This article has been commissioned by Co-operatives UK in the run-up to ‘Co-operation: How?‘ – the 2014 participative Congress that is exploring the scope for a co-operative economy, from banking to farming.