Fighting for the soul of Britain’s building societies

It is widely believed that the 2007-8 financial crisis was a crisis of big banks and investment banks. These unaccountable behemoths borrowed large amounts of volatile wholesale funding to use for highly risky speculative activities, putting both their solvency and their customers’ money at risk. Building societies, which have restrictions both on the extent of wholesale funding and the uses to which they may put it, were not involved in the highly risky speculative activities that were the proximate cause of the crisis. They were affected by the crisis, but they did not cause it.

Since the crisis, many customers have moved funds from banks to building societies, believing this will bring them increased safety and better service. The “banks bad, building societies good” meme has been heavily promoted by the building societies themselves, and by government – as well as a number of pressure groups. Nationwide, now the UK’s fifth-largest lender, ran an advertising campaign in 2013 aimed at attracting disaffected bank customers. “You need a bank account, but you don’t need a bank,” it said.

But is this belief in the soundness of building societies justified?

In September 2008, the Telegraph ran a feature called “How safe is your building society?” It correctly pointed out that former mutuals Northern Rock, Halifax, Alliance & Leicester and Bradford & Bingley had all failed in the crisis. But, the article added, building societies should be safer.

“Significantly, the member-owned structure of building societies protects them in two major ways,” the Telegraph said. “First, as already mentioned, they are not exposed to attacks on share price. Second, they are restricted in the amount of cash they can raise. This not only limited their participation in the now-scandalised securitised loan deals, but it stopped them growing too rapidly during the last boom.”

Yet further down the piece it noted that Derbyshire and Cheshire building societies were to be taken over by the Nationwide “before the end of the year” because of rising bad debts. It was a sign of things to come.

The Telegraph listed five building societies it regarded as “the best” of those remaining: Nationwide, Britannia, Yorkshire, Skipton and Chelsea. Of these, Chelsea was taken over by the Yorkshire in 2010, after it became apparent that it could not survive as an independent entity: it had lost £55m in the failure of Icelandic banks, and had been forced to write down £41m of “fraudulent loans” in its buy-to-let portfolio.

Also in 2010, Britannia joined with the Co-op Bank in an apparently friendly merger. Three years later, it was revealed that the Britannia’s balance sheet was riddled with toxic residential and commercial property loans. The consequences for the Co-op Bank were disastrous: writing down bad loans blew an enormous hole in its balance sheet, forcing the Co-op Group to obtain new capital from private sector investors.

Although the Co-op Group still narrowly retains the largest share, its ownership is severely diluted. There is no doubt that had the Britannia not merged with the Co-op, it would have failed in 2010.

Nor are these the only building societies that suffered in the financial crisis and its aftermath. Dunfermline Building Society actually failed and was nationalised like Bradford & Bingley: its remnants were eventually bought by the Nationwide. Scarborough and Chesham Building Societies were taken over by Skipton. Coventry merged with Stroud & Swindon. And Kent Reliance was bought by the private equity company J.C. Flowers.

Overall, the building society sector lost a fifth of its members. And many of those that survived were badly damaged: West Bromwich, for example, lost half its income.

Most building societies have had to restructure their balance sheets, unwinding non-performing loans and shedding unprofitable lines: many still have internal “bad banks” containing assets for disposal. Under pressure from regulators to improve capital and liquidity buffers, building societies have in recent years cut lending, particularly to higher-risk borrowers such as first-time buyers, and reduced rates to savers in order to improve profit margins. Their retrenchment has contributed to the UK’s slow recovery.

So the claim that building societies are “safer” than banks, and that they did not contribute to the crisis and its aftermath, appears unfounded.

But this is not quite what it seems. The building societies that experienced the worst problems in the financial crisis were those that behaved most like banks. They came unstuck due to excessively risky commercial and residential property lending funded by unstable wholesale funding – just as the banks did. The building societies that came off best were those that stuck to their traditional model.

In the wake of demutualisations in the 1990s, building societies were under pressure to compete successfully with banks. This no doubt drove their move into riskier activities and higher leverage in the search for market share. But with hindsight, this was a terrible mistake. In trying to compete with banks, they became indistinguishable from banks. We could say that they lost their soul.

The recent restructuring has forced building societies to focus again on the core functions that too many had forgotten – long-term stable deposit-taking and prudent, good-quality mortgage lending. The challenge now is to re-establish a vibrant, rejuvenated mutual
sector at the heart of the UK economy, supporting local communities and providing excellent customer service.