How well are financial mutuals really doing?

It seems I may have been too optimistic in this column a few weeks ago when I reported how well building societies were doing. In my column in early December I explained that the KPMG Building Society Database 2014 found that 35 of the remaining 45 building societies reported increased profits in the preceding financial year, with reserves rising to an all-time high of £13.7bn.

But this, of course, was a backward-looking assessment. The figures for the last quarter of 2014 were not so good, according to the latest CBI/PwC Financial Services Survey. One of the responses to the financial crisis has been for regulators to require mortgage lenders to take a tougher approach to lending criteria. The objective of what is called the Mortgage Market Review is to see fewer home buyers take on mortgage debt they cannot afford to repay, while also leading to fewer buy-to-let mortgages being approved for people with over-optimistic business plans. This is hitting building societies’ mortgage sales.

Rain Newton-Smith, CBI director of economics, explained: “Building societies have struggled this quarter, likely as a result of the impact of the Mortgage Market Review, constrained buyer affordability in London and the South East, and stronger competition in the mortgage lending market. But a strengthening of household finances, continued low interest rates and the recent changes to stamp duty suggest that conditions in the sector should pick up ahead.”

Banks and other financial services firms with a more diverse product range have been less affected by the impact of the Mortgage Market Review. But other changes from regulators have also severely affected financial mutuals, as this column has discussed in the past.

A significant element of the global financial crisis was caused by banks and other financial institutions making loans and investments that were excessive compared to their asset bases. To use the jargon of the finance industry, they became over-leveraged.

This was made worse by financial institutions’ asset bases becoming eroded. Commercial borrowers defaulted on debts, leading to banks making write-offs (meaning the assets became worthless ) or write-downs (the value of the assets declined). As well as commercial borrowers, many homeowners went into default on mortgages, under the impact of the recession.

The regulatory response to these problems has been to increase the capital requirements on banks, in particular. This is part of the reason why the Co-operative Bank went into crisis and demutualised. In most cases, putting more capital into a mutual involves its demutualisation, or partial demutualisation. The capitalisation usually sees a public share issue, which is incompatible with the status of a mutual.

There are alternatives to demutualisation – one of these might be acquisition by another mutual. Large building societies can also issue core capital deferred shares (CDDS). Unfortunately, another route used in the past to build up building society capital, the issuing of permanent interest bearing shares (PIBS), is no longer accepted by regulators as ‘at risk’ (‘Tier One’) capital.

But greed is also a continuing factor that erodes mutuality. The crisis for the financial co-operative and mutual sector is by no means restricted to the UK. A recent article in American Banker magazine reported that the demutualisation of US financial institutions accelerated last year, and that some US mutual financial institutions converted from member-owned organisations to joint stock institutions.

The positive side of this – for readers of the News, if not for US investors – is that there is a swing against this trend. American Banker reported: “Depositors and some mutual executives question whether conversions help the bank’s customers, or just the advisers who recommend them”. This helps to explain a likely slowdown in future demutualisations in the US. On the negative side, the expected reduction in conversions is also the result of the declining number of institutions left to demutualise.

The largest conversion last year was apparently that of a New Jersey-based institution, Investors Bancorp, which held $17.8bn (£11.8bn) of assets. Philadelphia’s Beneficial Mutual Bancorp and the New Jersey Kearny Financial are currently proceeding with conversions. Pressures for demutualisation in the US are to do with attempts to make money. Typically, the chief executives, non-executive directors and advisors all gain substantially in finance terms from the conversions. The demutualisations are not, in the main, to address capital weaknesses. Indeed, American Banker reports that the financial crisis held back some potential conversions because of the lack of capital to invest in demutualisations.

Kevin Handly, a banking attorney in Boston who advises mutuals, explained to the magazine the background to the demutualisations.

“The usual reason for a conversion is that the CEO and the board of directors have essentially given up and decided that they are no longer committed,” he said. “Investment banks make very handsome fees in doing these transactions, and they’re constantly pressuring these CEOs to convert. The conversion peddlers are constantly reminding CEOs and directors that they could get pretty rich off this transaction. They also say to them that, if they don’t do it, their successors will.”

Some financial mutuals have taken steps to protect themselves against demutualisation. Both the Reading Co-operative Bank and the Salem Five Cents Savings Bank have adopted measures, at the insistence of depositors, to protect against demutualisation. And depositors voted down a proposal from the directors at Beverly Bank to convert.

So, perhaps, there are indicators of hope. Engaging customers as members is one key element to protecting mutuality both as a principle and as a democratic practice. Financial mutuals in the UK should also bear this in mind, as should their members.

A NOTE FROM PAUL:

This will be my last column for Co-operative News, at least for a while. An excessive workload has squeezed out the time needed to research and write for the News. The last two years have been very demanding in terms of understanding what has been happening within the UK co-operative movement and have involved a significant time commitment. Thanks for the supportive feedback on the columns that have tried to explain the global recession and its impact on co-operative and mutuals.