Not so mutual at the Co-op

George Kerevan looks at this week’s upheavals in the financial sector…

Last month, Labour leader Ed Miliband gave a big speech on banking reform.  His carefully chosen venue was the HQ of the Co-operative Bank in Manchester. Hint: mutual banking with a social conscience is so much cosier than those nasty private banks like RBS.

Miliband praised the Co-op to the heavens: “You have always understood that ethics of responsibility, co-operation and stewardship must be at the heart of what we do. That’s one of the reasons why the Co-op Bank has in the last week seen a 25 per cent rise in applications for accounts.”

Unfortunately for Mr Miliband, the proverbial roof immediately fell in on the old Co-op.

First the bank was forced to announce it was halting loans to all new business customers. The emergency was necessitated by the need to plug a gaping hole in its capital reserves – a wonky balance sheet that caused Moody’s to downgrade the Co-op’s credit rating to “junk”. The shortfall was a cool £1.5 billion.

Yesterday came the inevitable restructuring: the bank’s bondholders are being forced to accept the transformation of their holding into shares – which is a polite way of saying they have lost their shirt. Around 7,000 of these bondholders are small retail investors and whose average investment is £1,000. 

The idea of mutual banking has also been torn up, as the new shares will be listed on the Stock Exchange. We will see how the market rates them, but I doubt if the new (forced) equity holders will make a turn any time soon. In 2012 the Co-op Bank generated income of £1.4bn but had operating costs of £713 million. Add in impairment losses, plus £150m for payment protection insurance claims, and the result was a loss of £662m.

The roots of the Co-op’s problems lie in its ill-advised takeover in 2009 of the Britannia building society. With other banks still recovering from the Credit Crunch, the “ethical” Co-op saw a chance to grab market share by gobbling up Britannia. Unfortunately, Britannia came with a subsidiary that had granted self-certificate mortgages. There were also a string of suspect commercial property investments.

As Lloyds found with HBOS, rescuing a failed competitor comes with very long strings. Also as in the Lloyds case, it did not help that politicians got involved to egg on the rescue as a way of tidying up a regulatory failure. Result: less due diligence took place than was warranted.  With 6.5 million customers and 1.5 per cent of current accounts, the Co-op was seen both by the previous Labour administration, and later by Chancellor Osborne, as a cheap way to create a new competitor to the existing high street banking oligopoly. Until recently the Chancellor was hoping the Co-op would relieve Lloyds of 623 of its branches Lloyd branches – a scheme that has bitten the dust due to the Co-op’s difficulties.

Did no one see this coming? Surely the bad debts inherited from Britannia must have been evident to someone? Perhaps Neville Richardson, the former boss of Britannia, who ended up as the new chief executive of the merged group? Richardson left under a cloud in 2011, with a £5m payoff.

I wonder why.

The Co-op Bank is part of the supermarkets-to-funeral parlours Co-op Group, which has assets of £82bn.  However, the new boss of the overall Group, Euan Sutherland, does not want to throw good money after bad. Indeed, he is rumoured to want to pull out of banking altogether. On the other hand, precisely because the Co-op Bank is a mutual, it can’t raise capital on the markets - hence the restructuring.

Where does this leave us?  Creeks and the absence of paddling equipment come to mind.

First, the attempt to create more competition among the high street banks is dead in the water. That is bad news for small business customers. Ignore the heavy briefing this week from Whitehall (following the dumping of Stephen Hester) to the effect that the next boss at RBS would be expected to lend more to business.  That was just Government spin to deflect bad headlines following the collapse in the RBS share price following Hester’s untimely exit.  

The truth is that total bank lending to the business sector is down in the first half of 2013 despite the Bank of England (through its new subsidy system) pumping the banks full of cheap funds.

Why? Because the Treasury speaks with a forked tongue.

On the one hand Vince Cable bleats about the need to provide more capital for SMEs. Yet on the other hand, the Coalition and the Bank of England are forcing bank’s to re-capitalise, which means less (not more) lending; or, at least, more costly lending. You can’t have it both ways. And as long as the big four high street banks have the market sewn up between them, the lack of competition ensures retrenchment and de-leveraging wins the day. 

Second, we are seeing more – and more risky – political interference in the banking system, not less. Chancellor Osborne is desperate to privatise at least part of the state holding in RBS and Lloyds before the 2015 General Election.

Hence the exit of Stephen Hester, who was against rushing things. And hence the exit of Paul Tucker, Deputy governor at the Bank of England, in order to give his new boss, Mark Carney, the freedom to crank up the money printing machine at the central bank in time for the voters to feel the economy is recovering.

Third, as the Co-op Bank experience proves, we have not fully recovered from the effects of the 2008 financial crisis. It is definitely not business as usual. Even the re-capitalisation of banks is suspect. Much of their new asset base is composed of sovereign bonds, courtesy of quantitative easing and other monetary innovations in the US, UK and Japan. Any sudden crash in the bond markets – triggered, say, by the US Federal Reserve withdrawing its monetary expansion programme - could have serious negative repercussions for bank balance sheets.

My conclusion may sound paradoxical: I think we may have bent the stick too far towards regulation and political interference since 2008. The credit crunch was the predictable result of low interest rates (engineered by central banks), a property bubble (encouraged by politicians) and excessive proprietary trading by banks (ignored by central banks). Ensuring we avoid such a dangerous mix in the future does not require mandatory massive capital reserves or the Chancellor having the power to dismiss bank CEOs who disagree with him.

My other conclusion concerns the Co-op Bank. The failure at the Co-op should be a warning to Ed Miliband and others who are tempted by simplistic nostrums to the effect that mutuality is automatically superior to private enterprise capitalism.

The best antidote to corruption – be it of political power or from business greed - remains free competition in the market place.Likewise, the solution to the problems with our banking system lies in more competition, not more regulation.