The ‘Big Bang’ reform of the capital markets in the City of London in 1986 marked the beginning of investment and universal banking, in place of the traditionally separate and narrower ‘merchant banking’ and commercial banking, in the UK.
Stock market ‘jobbers’, ‘makers’ and ‘traders’ were absorbed into investment banking units. This was all a change that set the scene for the 2007-9 financial crisis, some 20 years later. Completing the circle, the Independent Commission on Banking, in November 2011, recommended the ‘ring fencing’ of retail and narrow commercial banking from investment and trading, or ‘casino’ banking, and the Parliamentary Commission on Banking Standards that followed went further by calling for the ‘electrification’ of the ring fence in June 2013.
Also in 1986, legislation was passed to allow building societies to diversify, to offer current accounts and SME loans, and to demutualise if they could gain sufficient support from member owners.
The idea of demutualisation was not new – one of the early retail co-operatives, established by William King in Brighton, had dissolved, because the members could see the short-term gain of realising their assets, even if it meant a long-term cost as they fell back on the high-cost outlets that had led them to establish the mutual society in the first place.
The mutual sector has always had to find ways to balance the short and the long-term interests of members. The new legislation for building societies drove a coach and horses through that. A number of building society boards controversially offered financial inducements (derived from historic profits and reserves built by deceased members who perforce could not vote, and ignoring the rights of potential future members) and achieved affirmative votes.
Sensing the opportunity, speculative investors, dubbed ‘carpet-baggers’ opened accounts so they could vote for demutualisation and share the spoils. Many of the largest building societies, other than Nationwide, demutualised to become non-mutual, shareholder-owned, ‘mortgage banks’. Abbey National, the second largest at the time, in 1989; Cheltenham & Gloucester in 1995; Halifax, by far the largest, in 1997; and Bradford and Bingley in 2000; and, of course, Northern Rock, in 1997, which subsequently grew extremely rapidly.
This enabled them to raise new capital by issuing ordinary shares and thus to expand more rapidly. Some dabbled more than others in SME lending; others in ‘buy-to-let’ mortgage origination (Bradford and Bingley) and property development lending; in addition to traditional mortgage lending.
These mortgage banks increasingly adopted the ‘originate-to-distribute’ model following the lead of progressive exponents such as Northern Rock, based on the issuance of mortgage-backed securities (MBS) which could package portfolios of mortgages and sell them on to investors.
100%, and in some cases more, ‘loan to value’ ratio mortgages became available to borrowers and 95% loan to value mortgages were commonplace. Wholesale funding (restricted to 50% of deposit liabilities in the case of mutual building societies) was secured using (mortgage) asset-backed commercial paper issuance.
Northern Rock and others were using off balance sheet special purpose vehicles (‘special investment vehicles’, or ‘SIVs’ and ‘conduits’) to facilitate securitisation and the construction of derivative financial instruments, such as ‘collateralised debt obligations’. These ‘sliced and diced’ the MBSs to form products of varying credit standing, from top ranking ‘Triple A’ assets to ‘toxic waste’, the most risky assets which earned the highest returns.
It is widely observed that the fastest growing banks are the most likely to be the ones taking the risks other banks are choosing not to take on; but as ‘the music’ kept playing and everyone was passing the ‘parcels’, the mortgage originators or lenders and non-public sector ‘securitizers’ and ‘derivitizers’ (mainly investment banks) kept dancing, as Chuck Prince, the CEO of Citibank, observed.
Finally, in August 2007, the North Atlantic Liquidity Squeeze ensued as banks lost confidence in each other’s credit worthiness and stopped lending to each other through the interbank wholesale money markets. Northern Rock’s model became unsustainable; leading to a ‘run’ on the bank in September 2007 when its depositors lost confidence and famously queued outside it branches to withdraw their money in cash.
The subsequent 2007-9 financial crisis brought down all the rest of the independent UK mortgage banks. They were absorbed into mainstream banking groups, which subsequently had to resolve the problem loan portfolios they had built up as a result of rapid expansions of ‘buy to let’ and ‘subprime’ mortgage lending and commercial property loans.
There were remarkably few defaults on traditional home loans, in part because of the dramatic cuts in interest rates instigated by the Bank of England in response to the collapse of the interbank liquidity market, the subsequent financial panic crisis and resulting ‘credit crunch’ and some judicious forbearance and debt rescheduling and restructuring by the bank lenders.
As I noted in my first article, the first building society was established in Birmingham. It was a ‘terminating’ self-help group set up to enable its members to save up in order to finance the building of houses for its members. Such societies were not intended to be open to new members. By 1870 there were 959 terminating building societies and they had become the core providers of mortgage finance for skilled working class people. Over time many became ‘permanent’ and sustained themselves by admitting new members and they grew, but commonly remained in local areas and took the names of their towns, districts and cities (Chelsea, West Bromwich, Coventry, Halifax, Bradford and Bingley, Leeds Permanent and so on).
The Nationwide is a union of an increasing number of societies having merged with Anglia to form, for a period, Nationwide-Anglia in 1987, before reverting to Nationwide, and then Portman in 2007.
It then absorbed troubled small societies in the crisis (Cheshire, Derby and Dunfermline) and is now larger than the 43 other remaining societies in the Building Societies Association in aggregate. Nationwide is able to offer a broad range of retail banking services; although it recently stepped back from wider SME lending. Post 1986, building societies could only offer current account banking using ‘clearing’ banks, which owned the payments systems, as agents.
Subsequent reforms of the payments systems enabled the larger building societies to become members and offer current accounts in their own right, saving agency fees and offering customers a better service so they no longer had to wait a couple of days longer for cheques to clear than traditional ‘clearing bank’ customers and money paid into current accounts by employers could be withdrawn immediately, again rather than having to wait a couple extra days. Nationwide’s membership voted against a motion to demutualise in 1998 and then in 2001 its board rebuffed a second attempt, led by ‘carpet-baggers’, to demutualise it.
The process of demutualisation changed Britain’s banking landscape for the worse. This is an illustration of how regulation and markets co-evolve. If policy favours investor-owned models of business, then investor-owned businesses will win out.
Demutualisation was an undoubted failure, as the shareholder owned mortgage banks that resulted all failed. At the same time, with only one new entrant in recent decades, the Ecology Building Society, the building societies themselves have become, while still vigorous, distinctive and competitive, something of a closed island of mutuality rather than joined to a wider mutual banking continent.
For cultural, governance or other reasons, the UK building society sector has not been very effective at secondary co-operation – compared to the German co-operative banks, which audit each other and share capital, or the highly successful, federated model of Desjardins, bringing together 376 credit unions (caisses populaires Desjardins) serving 5.8million members in Canada.
This may change – and it is no coincidence that the Building Societies Association has recently joined the European Association of Co-operative Banks: there may be scope for pooling risk and pooling capital, whether at a European level or, more likely across regulatory regimes with the strongest co-operative banks worldwide.
In my next article, I will look at who decides: the core issue of governance for mutual institutions – why it matters, and why, ultimately, it may point to a new more local focus for new co-operatives and mutuals in banking.
• Read the first article in this series. 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.