Supplementary written evidence submitted
by the Co-operative Financial Services
CORE CAPITAL FOR MUTUAL AND CO-OPERATIVE
BANKS
Thank you for the opportunity earlier today to explore
our thoughts on competition and choice in the banking sector.
During the hearing, you indicated that it would be helpful if
I set out details of the issues faced by mutuals and co-operatives
in the current changing regulatory landscape. Accordingly I set
out our thoughts below.
CONTEXT
If mutuals were not to have access to Core Tier 1
capital other than through retained earnings, the sector will
be affected in three main areas:
The boards of mutuals will not have the ability to
manage and grow their balance sheets flexibly and, as a result,
will be hampered in their ability to ensure that their members'
interests are best served and protected. Balance sheet growth
will be constrained to the uneven (and currently very modest)
rate at which organic capital can be generated from retained earnings,
and this will have an unwelcome procyclical effect. (Nor can organic
capital be generated overnight to respond to — for instance
— sudden increases in capital requirements, or the step
change effect of regulatory capital deductions which are increasingly
taken against core capital). This means mutuals will be less able
to maintain lending in a downturn, and will be less able to provide
effective competition to banks. So the playing field will be far
from level and competitive disadvantage will result from no access
to external core capital. Reserves built up from retained earnings
are expected to remain the predominant form of capital overall
for mutual and co-operative deposit-takers in the UK, but from
time to time some of them will need access to external capital
for specific reasons.
The sector will also be viewed as second tier as
it has not been afforded equal treatment to financial institutions
which are organised as joint-stock companies with the resulting
negative connotations associated with such a view. This is inconsistent
with HM Government's commitment in its document The Coalition:
our programme for government which states:
"We will bring forward detailed proposals
to foster diversity in financial services, promote mutuals and
create a more competitive banking industry."
The ratings agencies will also be forced to take
a negative view on the sector compared with financial institutions
organised as joint stock companies, as the ability of mutuals
to create capital will have been restricted and will become more
dependent on the economic cycle. This restriction will not only
apply to Core Tier 1 but will also affect the ability of the sector
to issue contingent capital as there will not be a valid "go-to"
instrument. This negative view could well translate into ratings
downgrades across the sector as a whole which will have a knock-on
effect on the ability of the sector to access the wholesale markets
for funding. None of this is positive for financial stability
in the UK.
BACKGROUND
The UK's mutual sector has outlined a principles-based
approach to modification of the core capital criteria proposed
in Annex IV of the European Commission's February 2010 consultation
document on CRD 4. We argued that such modifications should not
be based on existing national peculiarities or special pleadings,
but on transparent, existing pan-European principles. The relevant
principles are those already recognised in European law in the
recitals to the Statute for the European Co-operative Society,
namely limited interest on capital, open membership and disinterested
distribution. Together with the Building Societies Association,
we have worked with the European Association of Co-operative Banks,
in order to press this case in pan-European terms.
The final guidelines from the Committee of European
Banking Supervisors (which since the beginning of the new year
has become the European Banking Authority) on Article 57a (core
capital) instruments and the accompanying feedback statement,
were in fact most helpful in advancing the cause of mutuals and
co-operatives. That said, CRD2 and CEBS guidelines unfortunately
do not accommodate the legal structure of UK co-operatives in
the modifications applicable to mutuals and cooperatives, and
amendments are required.
This structure and the related issues are described
in detail below on catering for UK co-operatives. It is
also important to ensure that the CRD 4 drafting is both sufficiently
explicit on these matters — as the CEBS guidelines were
— so as to avoid what we call "interpretation risk"
and also does not introduce any other provisions that are damaging
to mutuals' and co-operatives' ability to raise core capital.
Indeed CRD 4 should seek to create parity between mutuals, co-operatives
and other banking entities.
On a positive note the Treasury has recently proposed
the following wording for inclusion in CRD4. We welcome the Minister's
support for this so far, and encourage the Minister to give this
a high priority in UK negotiations at a European level.
58(1)
"Common Equity Tier 1 capital instruments set out in paragraph
1a of Article 57a shall include any other instrument:
(a) issued under the specific constitutional and
legal structure of a mutual, cooperative society or
similar institution; or
(b) issued by a credit institution in which, and for so long as,
a mutual, co-operative society or similar institution holds 100%
of the ordinary shares;
and which is deemed fully equivalent to an ordinary
share in terms of its capital qualities regarding loss absorption,
and does not possess features which could cause the condition
of the credit institution to be weakened as a going concern during
periods of market stress,"
58(2)
"Instruments issued in accordance with Article 58(1) may
be subject to a dividend cap provided that the primary purpose
of the cap is to limit distributions to investors and protect
the reserves of the credit institution. The credit institution
may indicate to the market that where possible it intends to pay
dividends at or below the level of the cap, provided that at all
times the credit institution shall retain full discretion over
the payment of dividends and shall exercise that discretion to
stop or reduce dividend payments in order to protect reserves
in accordance with the level of distributable items [or to build
up reserves where necessary to do so]. The credit institution
shall regularly review the cap and whether it is appropriate to
use the cap as a level of intended dividend."
SPECIFIC POLICY
PROPOSALS
(i) Catering for UK co-operatives
There remains a challenge for co-operatives. UK co-operatives
are generally incorporated as industrial and provident societies
and consequently cannot undertake banking business directly. In
order to accommodate UK legal and regulatory requirements, in
1971 what was previously the banking department of the Co-operative
Wholesale Society had to be separately incorporated as the Cooperative
Bank, a wholly-owned company subsidiary of an I&P society.
That is why the BSA has consistently urged the Authorities to
ensure that principles-based modifications for mutuals or co-operatives
in CRD 4 should apply to their respective groups, whether or not
specific group entities are structured as companies, and this
is clearly needed where the use of a company subsidiary is necessitated
by national law or regulation.
For a banking business which is a subsidiary of a
UK co-operative, this means that the bank should be able to issue
capped core tier one instruments to raise external capital without
prejudice to its ability to make uncapped distributions to its
I&P parent.
The structure of a mutual group with a joint stock
company as a subsidiary is also required under UK law specifically
in the Building Societies (Funding) and Mutual Societies (Transfer)
Act 2007 ( the "Butterfill Act") which provides a framework
for merger of one type of mutual with another type of mutual.
It is a requirement of the Butterfill Act that any merger of two
different mutuals must be effected by the transfer of the business
of the transferring mutual to a subsidiary of the acquiring mutual,
with membership rights conferred in the acquiring mutual itself.
The acquiring mutual's subsidiary must be a Companies
Act company or a body corporate incorporated in another EEA state.
Given that such a UK co-operative structure is prescribed by UK
law, clearly it needs to have the ability to issue a core tier
one capital instrument of a similar nature and with similar features
to the instrument proposed for mutuals which are building societies.
Indeed there seems no legal basis to draw a distinction between
such a UK co-operative structure and building societies in respect
of the issue of core tier one capital instruments since they adhere
to the same mutual principles. To underline this point, that the
subsidiary, although having the form of a joint-stock company,
operates as a co-operative business, we draw attention to the
feature, in the CFSI Co-operative Bank structure, that
the bank's customers are entitled to membership of the top co-operative,
and that anyway membership in the new holding mutual is a requirement
for any kind of transfer under the Butterfill Act.
(ii) Flexibility on caps
The CEBS guidelines fully accept the principle of
capping distributions on the core capital instruments of mutuals
or co-operatives, making the further, and helpful, link that these
caps operate to protect the reserves from over-distribution, and
are therefore prudentially desirable. The final guidelines have
also taken the step that such a cap may be provided for either
in national law or in the constitutional documents
(ie Rules or Articles) of the mutual or co-operative. There may
however be potential ambiguity as to how this needs to be specified.
In this context it is important to avoid being drawn too closely
towards the current French model, where the Ministry of Finance
determines the cap (ie the actual numerical percentage rate) twice
a year and this applies to all French mutual or co-operative banks.
Instead, we need to clarify that national law, or
the Rules, needs to provide for there to be a cap, but that the
actual percentage level of the cap should be left for the different
issuers to decide. The desired outcome is (i) that different mutual
or co-operative institutions can make their individual decisions
on where to set a cap, (ii) this can be decided in the context
of an actual issue (whereas enabling rule changes will have been
made some time in advance) and (iii) if possible, setting different
caps for different issues by the same institution should not be
precluded.
(iii) Interpretation risk
There is a wider concern, deriving from the experience
of the UK discussions on Mutual core tier 1 and CRD 2/CEBS, which
we describe as "interpretation risk" that is, provisions
which are initially taken to have a clear, explicit meaning may
be subject to later interpretation, on a "purposive"
basis, producing a result some way from the explicit meaning of
the provisions (and connected perhaps to the separate agendas
of the interpreting authority). In that context we note inter
alia the potential future risk from binding rulings of the European
Banking Authority in place of the persuasive but non-binding guidelines
of CEBS. CRD 4 drafting must therefore minimise any interpretation
risk to mutuals and co-operatives. A particular instance of this
concerns "pre-indication". As we have argued recently,
all securities, even ordinary shares, are sold with some pre-indication
of expected return. In the case of an IPO of ordinary shares,
this takes the form of a formal dividend forecast for the current
or next accounting period, and a dividend policy: these cannot
be contractual, but they must be made or given in good faith after
due diligence, since they are intended to, and do, influence the
behaviour of prospective investors.
The current language in the CEBS guidelines (paragraphs
69 to 71) sensibly recognises that institutions (both proprietary
and mutual/co-operative) may disclose a dividend policy. But the
term "pre-indication" is too vague and more clarity
is required.
I trust this addresses your request for further background
information that you might raise with the Financial Secretary
to HM Treasury at the next meeting of the Treasury Select Committee
on 2 February 2011.
February 2011
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