Co-op Bank investigation: is regulator’s public censure enough?

The UK’s twin financial regulators, the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA), have publicly censured the beleaguered Co-op Bank for serious regulatory failures. The PRA’s...

The UK’s twin financial regulators, the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA), have publicly censured the beleaguered Co-op Bank for serious regulatory failures.

The PRA’s censure relates to the circumstances of the Co-op Bank’s acquisition of Britannia Building Society in 2009 and its management of its loan books from then until the change of management in 2013. This covers the entire period of Neville Richardson’s tenure as chief executive, and that of his successor, Barry Tootell.

The PRA’s findings can be summarised as follows:

  • The Co-op Bank had no effective risk management and control function
  • The Co-op Bank persistently fudged its accounting to make its current financial position appear better than it was.

These are very serious criticisms. In the PRA’s press release, its CEO, Andrew Bailey is scathing:

“Firms must have in place strong controls and sound risk management, as operating without them undermines safety and soundness. Co-op Bank’s failings stand out both for the duration and seriousness of the risk management and control deficiencies uncovered.”

The PRA judged the Co-op Bank’s failures to be serious enough to warrant a fine of £121.86m. Compared to the billion-pound penalties imposed on other UK banks for regulatory transgressions, this looks like chicken feed. But it is in fact 20% of the Co-Op Bank’s entire operating revenue in 2013. That is an enormous penalty.

In September 2013, Neville Richardson defended his performance to the Treasury Select Committee, claiming that the disastrous state of the Co-op Bank’s books was entirely due to the economic climate and that when he left the Bank in mid-2011 it was well-managed, profitable and there were no signs of any problems in its asset base. The 2011 accounts certainly do paint a rosy picture.

But questions should have been asked at that time about the Co-op Bank’s risk management. In September 2013 I did my own analysis of the bank’s financial position from its published accounts. And I was shocked by what I found.

In the 2011 full year report, an astonishing £3,570.5m out of a total loan portfolio of £11,053.7m were described as “unrated” for credit risk – almost a third of the entire portfolio. By the time of the 2012 full year report the number of “unrated” loans had declined to £2,587.1m out of a total portfolio of £11,402m, slightly less than a quarter. But loans in default had increased from £921.3m to £1,994.7m. The majority of these (£1,424.1m) were in commercial property investment, and were downgrades of loans that had previously been rated as “good” or “satisfactory”. It is simply not credible to blame such a massive increase in defaulted loans entirely on the economic climate. The fact is that in 2011 the Co-op Bank had a large number of loans that it either hadn’t assessed for credit risk at all, hadn’t reassessed recently, or had assessed far too optimistically. The bank under Richardson was not in control of its loan book.

The PRA, conducting a far more robust investigation than I did, has reached similar conclusions. Loan valuations were over-optimistic, non-performing loans went unreported and a large part of the book simply wasn’t managed at all. It was a massive failure of management and control.

But there is a second strand to this which is even more worrying. Both the PRA and the FCA complain that the Co-op Bank withheld information on senior management changes from regulators. Furthermore, the FCA censures the Co-Op Bank for issuing “misleading information”. I think the FCA is being kind: “lies” is what I would call it. The Co-op Bank claimed in its 2012 report and accounts that it was maintaining a capital buffer sufficient to withstand both ordinary and extreme stresses. But in fact it already knew it had a serious capital shortfall.

This is consistent with the PRA’s finding that the bank routinely presented a rosier picture of its finances than was in fact the case. The PRA’s observation that the rosy bias stemmed from the bank’s culture is particularly worrying. Bank culture is notoriously hard to change: although management has been replaced at Co-op Bank, people could be forgiven for wondering whether the figures are wholly credible even now. Do leopards change their spots?

The regulators seem to be hoping they do. The PRA has chosen not to impose its £121m fine, and the FCA is not imposing a penalty at all, because to do so would seriously set back the Co-op Bank’s recovery.

It should be remembered that the Co-op Bank is lucky still to be standing: not only did it nearly collapse in 2013, but it also failed the Bank of England’s stress tests in the autumn of 2014. The “adverse scenario” in the stress tests, which modelled a severe housing market crash, entirely wiped out the Co-op Bank’s capital and left it in severe liquidity distress. Arguably, the Bank of England should have wound it up. Instead, it required the Co-op Bank to put forward a plan to improve its capital and liquidity buffers. This plan was agreed by the PRA, which is now closely monitoring the bank’s performance.

But there is no quick fix. The Co-op Bank currently fails to meet PRA capital requirements and even under the plan will not meet them until 2018. Its income is only barely covering its costs, not least because it had to take on an expensive revamp of its IT systems after pulling out of the Lloyds TSB acquisition. Recovery is a slow process for a bank as damaged as this – and is why, despite the seriousness of the regulators’ censure, financial penalties have not been imposed. Georgina Philippou at the FCA spells it out:

“This is a serious matter, but exceptional circumstances mean a public censure is the appropriate and proportionate response. It is vitally important that Co-op Bank’s capital resources are directed towards improving its resilience.”

The Co-op Bank has been given yet another reprieve. But Andrew Bailey of the PRA makes it clear there will be no more:

“The PRA has not levied a fine in this instance but, if any future enforcement investigation into Co-op Bank found serious and wide-ranging failings, this censure will be a relevant factor in determining the outcome.”

The Co-op Bank’s current management should take these findings seriously.

And what of the people involved? Surely Flowers, Richardson and Tootell deserve censure, and perhaps others too? The regulators somewhat cagily say that “investigations into senior individuals at Co-op Bank during the relevant period are on-going.” We will have to wait and see what, if any, actions are taken to hold these people to account.

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