House of Commons - Project Verde

Project Verde - Treasury Contents

4 The financial collapse of the Co-operative Bank

Introduction

83. Over the second half of 2012 and the duration of 2013, Co-op Bank's financial position deteriorated significantly. Co-op Bank reported significant loan impairment and other losses in its public financial statements (see Table 1), and a significant shortfall against its regulatory capital requirements emerged.

84. Co-op Bank's reported losses and its shortfall against regulatory capital requirements are distinct, but related. This section examines the three most significant and measurable factors that led to the bank's capital resources being diminished—large impairment losses on Co-op's loan book, particularly on assets acquired from Britannia, write-downs in the value of Co-op's banking system upgrade, and conduct redress. It also examines the effect of the Verde deal on Co-op Bank's finances, other factors contributing to the bank's capital shortfall, and the consequences of Co-op Bank's financial collapse for the Verde bid.Table 1 - Total impairments and significant items reported by Co-op Bank over 2012 and 2013

£m 2012 2013 Total

Credit impairments 469 516 985

Core 40 40 80

Non-Core 429 476 905

Of which corporate 425 447 872

IT write-down 150 148 298

Conduct redress 150 412 562

Other significant items 94 208 302

Total impairments and significant items 863 1,284 2,147

Source: Co-op Bank Financial Statements 2012, Co-op Bank Annual Report and Accounts 2013; note that 'Core' and 'Non-core' assets were redefined in 2013, and these figures are presented using that definition. 'Other significant items' comprises non-operating costs and Fair Value Amortisation.

Britannia and other impairments

THE MERGER WITH BRITANNIA

85. When Co-op and Britannia decided to merge in 2008, Co-op engaged external advisors to assist with its assessment of the deal. KPMG was engaged to perform due diligence on Britannia, and JP Morgan Cazenove (JPMC) was hired as a financial advisor on the transaction.[132] KPMG was paid £1.3 million—£841,000 for due diligence and the remainder for associated pieces of advisory work.[133] JPMC's fee was £7 million in total—£2 million up front, and £5 million on completion.[134]

86. David Anderson told us that Co-op's own rationale for the merger included greater 'distribution reach'—through Britannia's branch network—and mortgage expertise that would help Co-op move away from unsecured lending.[135] JPMC's analysis showed that the merger would result in the profits, net assets and dividends of Co-op members being diluted by the inclusion of Britannia members (Table 2).[136] But JPMC agreed with David Anderson's assessment, concluding that, with key benefits to customers including improved distribution and "product offering", the merger was a "one-off transformational opportunity" for Co-op.[137] As is clear from the assets of the two firms at merger (Table 3), the deal was indeed transformational for Co-op Bank—Britannia's large portfolio of non-standard mortgages and commercial real estate assets totally changed the shape of the bank's business. It also resulted in a large increase in Co-op Bank's dependence on wholesale funding (see Table 3).Table 2 - JPMC's 'Side by side analysis' of Britannia and Co-op Group

Britannia Co-op Group

Voting members 57% 43%

Profit before tax (PBT) 2007 30% 70%

Net assets 2007 25% 75%

Dividend 2007 32% 68%

Source: JP Morgan Cazenove 'Project Vintage Board Paper', 2009, (PV 13) page 273

87. KPMG was commissioned to examine ten key areas of risk arising from the transaction, as specified by Co-op: impairment; commercial lending; available for sale assets; funding and liquidity; taxation; securitisation; accounting policies; pensions; capital, and adjusted earnings.[138]

88. KPMG performed initial, 'Phase I' due diligence on these areas, and concluded on Britannia's commercial loan book that, apart from two specific tenants, "[no] arrears are being experienced in either the housing association or pure commercial lending portfolios".[139] However, it also drew Co-op Bank's attention to "significant limitations" in the scope of its work:

140

Andrew Walker, Lead Audit Partner on KPMG's due diligence on Britannia, told the Committee that KPMG recommended that further due diligence on the commercial book "should be done as part of phase II".[141] Asked how hard KPMG pressed for this additional work to be done, Mr Walker said: "Other than pointing it out in our report and spelling that out for management, no further."[142]

89. Rather than engage KPMG on this further due diligence, Co-op Bank decided to perform it itself. According to David Anderson, Co-op considered Britannia's commercial loans to be "closer to the lending that [Co-op] did as a bank" than other elements of the Britannia book. Co-op Bank therefore focused KPMG on "things that we did not do as a bank, which were the sub-prime, the intermediary lending and the securitisations, of which we had significantly less experience", and sent in its own team to examine the commercial loan book.[143] David Anderson described the team performing the additional due diligence on the corporate book as "a very, very experienced risk team, who we relied upon to put all our own corporate loans on the book".[144] Asked whether KPMG ever saw the results of Co-op Bank's further work, Andrew Walker said:

145

However, Mr Walker added:

146

Table 3 - Simplified composition of Co-op Bank and Britannia assets in 2008/09

£ bn	Britannia (July 2009, at merger)	Co-op Bank (December 2008, last reported figures before merger)
Total assets	34.0	15.0
Of which loans	23.8	10.3
Retail loans	20.1	5.7
Standard mortgages	10.7	4.1
Non-standard mortgages	9.4	0
Other (unsecured, e.g. credit cards)	0	1.6
Corporate loans	3.7	4.6
Property and construction (commercial real estate)	3.7	1.6
Other corporate loans	0	3.0
Customer deposits	19.9	11.9
Wholesale funding	10.4	1.6

Source: Britannia Cessation Accounts, Co-op Bank Financial Statements 2009. 'Non-standard mortgages' comprise loans secured on residential property which do not conform to traditional mortgage lending standards. They include buy-to-let mortgages, self-certification mortgages (where the lender does not have documentary proof of the borrower's income), and loans to higher risk borrowers (such as those with high existing debt levels, or with poor credit or other histories).

90. In his report into the events at Co-op Bank, Sir Christopher Kelly cast doubt upon the quality of the additional due diligence:

147

Overall, Sir Christopher describes the due diligence on Britannia's corporate book as "cursory", and concludes:

148

This did not prevent JPMC describing the due diligence to the Co-op Bank board at the time as "exceed[ing] that normally undertaken for listed companies".[149] David Anderson, Chief Executive of Co-op Bank at the time of the merger, also described this due diligence as "very full".[150]

91. Commenting on the results of the due diligence, Mr Anderson said:

151

One individual interviewed by Sir Christopher's review appears to have taken a stronger stance, describing the Britannia book as "the worst lending I have ever seen".[152]

92. In response to the risks identified, Co-op Bank made a number of downward fair-value adjustments to the Britannia assets upon acquisition. An asset's fair value at acquisition is equal to the discounted expected future cash flow from that asset at acquisition. Fair value adjustments reflect the difference between this fair value and the current carrying value on the acquiree's balance sheet. Mr Anderson said the adjustments made to the Britannia assets—including £238m to protect against credit risk to the corporate book—"looked like a pretty solid insurance policy against problems that may arise in different parts of the book".[153] Mr Anderson added that, at the time, Britannia's commercial book seemed unlikely to be the main source of potential risk to Co-op Bank (see Table 3):

154

The fair value adjustments made were assessed and "blessed" by KPMG.[155]

93. At the same time, the regulator was performing its own analysis on the possible effects of the merger. The FSA had no formal, legal role in the merger, since it involved mutual firms and was not therefore strictly a 'change in control' requiring regulatory approval. Nevertheless, Clive Adamson, director at the FSA at the point of merger, told us: "I decided we should go well beyond what was legally required and treat it as close to a change of control as we could".[156] Describing the FSA's analysis, Mr Adamson told us:

157

94. As described previously, none of the parties involved considered the merger a rescue of any sort at the time: David Anderson told the Committee that, although there were risks involved in merging with an unknown entity in such a febrile period, Co-op believed that "the risk of the two organisations together was less than the risk of each separately and less than the risk of our organisation separately"; Neville Richardson said that the merger "was not a rescue"; the former board of Britannia told us that it "was not a rescue of either party"; and Clive Adamson said that "[i]t certainly was not in our view a rescue".[158]

95. The merger went ahead on 1 August 2009. At the end of 2008—the final full year before the merger—Britannia had Tier 1 capital resources of £1,158 million: a Tier 1 capital ratio of 10%.[159]

96. For the next three years, impairments continued at low levels. This persisted even as other banks reported significant spikes in impairment losses, particularly in 2009 (see Table 4). Statements from senior members of Co-op Bank over this period made reference to the bank's prudent business model. In Co-op Bank's 2011 Financial Statements, Barry Tootell, Chief Executive wrote:

160

In the same set of financial statements, Chairman Paul Flowers wrote:

161

And in an article in January 2012, Mr Flowers linked Co-op Bank's financial performance to its ethical policy:

162

Table 4 - Impairment losses on loans and advances to customers at major UK banks, 2007-2013

£ m	2007	2008	2009	2010	2011	2012	2013
Co-op Bank and Britannia	116	155	161	97	121	474	516
Barclays	2,782	4,913	7,358	5,625	3,790	3,303	3,062
HSBC Bank	1,043	1,864	3,364	1,633	1,122	1,213	1,102
Lloyds and HBOS	3,733	12,732	15,783	10,727	8,020	5,125	2,725
Nationwide	106	394	549	359	390	589	380
RBS	2,106	6,360	13,056	9,157	7,241	5,292	8,427
Santander	344	348	773	712	501	988	475

Source: The Co-operative Bank plc, 'Financial statements 2007', page 41; The Co-operative Bank plc, 'Financial statements 2009', page 36; The Co-operative Bank plc, 'Financial statements 2011', page 30; The Co-operative Bank plc, 'Annual report and accounts 2013', page 128; Britannia Building Society, 'Annual report and accounts 2008', page 26; Britannia Building Society, 'Report and cessation accounts', page 13; Barclays Bank plc, 'Annual report 2007', page 33; Barclays Bank plc, 'Annual report 2010', page 87; Barclays Bank plc, 'Annual report 2013', page 292; The Royal Bank of Scotland Group, 'Annual Report and Accounts 2007', page 154; The Royal Bank of Scotland Group, 'Annual Report and Accounts 2010', page 328; The Royal Bank of Scotland Group, 'Annual Report and Accounts 2013', page 437; HSBC Bank plc, 'Annual report and accounts 2007', page 30; HSBC Bank plc, 'Annual report and accounts 2009', page 30; HSBC Bank plc, 'Annual report and accounts 2011', page; HSBC Bank plc, 'Annual report and accounts 2013', page 128; Santander UK plc, '2007 Annual Report on Form 20-F', page ; Santander UK plc, '2010 Annual Report on Form 20-F', page 186; Santander UK plc, '2013 Annual Report', page 238; Nationwide, 'Annual Report and Accounts 2008', page 12; Nationwide, 'Annual Report and Accounts 2010', page 11; Nationwide, 'Annual Report and Accounts 2012', page 16; Nationwide, 'Annual Report and Accounts 2014', page 18; Lloyds Banking Group, 'Annual report and accounts 2008', page 122; Lloyds Banking Group, 'Annual report and accounts 2010', page 178; Lloyds Banking Group, 'Annual report and accounts 2013', page 240; HBOS plc, 'Annual report and accounts 2008', page 73. Nationwide's financial year runs to 4 April; for example, '2010' means the year to 4 April 2011. Co-op Bank and Britannia figures, and Lloyds and HBOS figures, for 2007 and 2008 are formed by summing the figures for the individual banks prior to the mergers. Co-op Bank and Britannia figures for 2009 are formed by summing the year-end Co-op Bank figures with the standalone Britannia figures up to 31 July, as shown in the Britannia Cessation Accounts.

NEW REGULATORY GUIDANCE AND THE CAPITAL SHORTFALL

97. In the second half of 2012, the FSA began a round of stress testing on UK banks. Alongside this, the regulator was performing a review of the quality of banks' assets.

98. At its meeting in November 2012, the Financial Policy Committee (FPC) discussed what appeared to be an emerging picture of under-provisioning by banks against future impairment losses. The FPC noted:

163

The FPC said that concerns were especially apparent "for some UK commercial real estate (CRE) lending", adding:

164

"Under-recognition of expected losses", the FPC concluded, "would imply that the banking book valuations of banks' assets were overstated".[165]

99. The FPC therefore recommended that the FSA take action "to ensure that the capital of UK banks and building societies reflects a proper valuation of their assets", and, where capital buffers were revealed as being in need of strengthening, "to ensure that firms either raise capital or take steps to restructure their business".[166] The following month, the FSA sent a letter to all UK banks "concerning the interpretation by banks of the provisioning standards".[167]

100. David Davies, still at that point Deputy Chairman of Co-op Bank, described the letter to the Committee:

168

While Co-op Bank had been set to record year-end impairment losses of £185 million for 2012, its response to the letter boosted the final reported figure to £474 million.[169]

101. The FSA's stress-testing and asset quality review work continued into 2013. Based on a range of factors, the regulator reached a judgement on the impairment losses in excess of existing provisions that could emerge over the three years from December 2012. It also considered costs that firms might incur over the same period as a result of LIBOR fines and conduct redress.[170]

102. In November 2012, the FSA had informed Barry Tootell, then Chief Executive, that the stress tests would lead to a "quite markedly larger capital requirement" for Co-op Bank.[171] In January 2013, the regulator gave Co-op Bank its first indication of that heightened level of capital.[172]

103. The final results of the PRA's capital exercise for major UK banks were announced in June 2013. The regulator—by this time the PRA, following the split of the FSA into separate prudential and conduct supervisors—took the results of its stress tests, and assessed the banks' resulting capital positions against the Basel III, 7 per cent Common Equity Tier 1 standard.[173] This followed a recommendation by the FPC at its meeting on 19 March 2013 that banks should attain such capital levels as a near-term objective by the end of 2013.[174] On this basis, the PRA announced that Co-op Bank had a capital shortfall of £1.5bn; in comparison, its core capital resources at the end of 2012 had been £1.7bn.[175] Andrew Bailey told the Committee that this £1.5 billion shortfall was different to the £900 million that he had told Co-op Bank it would need to raise in July 2011:

176

Table 5 - Results of PRA capital exercise, June 2013

£ bn	Barclays	Co-op	HSBC	Lloyds	Nationwide	RBS	Santander UK	Standard Chartered
Core capital resources (end-2012)	40.7	1.7	77.6	28.0	4.3	37.2	8.5	20.0
Risk-weighted assets at end-2012	476.0	21.3	823.1	342.8	49.6	576.9	81.0	205.2
Regulator's adjustments to capital resources	-8.6	-1.5	-7.8	-12.1	-0.4	-7.1	-0.7	0.0
Regulator's adjustments to risk-weighted assets	+24.7	0.0	+45.0	+8.3	+10.6	+56.3	+5.6	+19.0
Additional capital raising required as a result of PRA capital exercise (beyond that already in banks' plans)	1.7	1.5	0.0	7.0	0.0	3.2	0.0	0.0

Source: Prudential Regulation Authority website

WHY WAS CO-OP AFFECTED SO BADLY AND SO LATE?

104. Peter Marks did not appear to accept that primary responsibility for the capital shortfall resided with Co-op. He pointed to changes in regulation as the primary cause of Co-op's financial difficulties, telling the Committee:

177

105. The PRA provisioning guidance applied, however, to all UK major banks and building societies. Andrew Bailey told the Committee:

178

As is clear from Table 5, Co-op Bank was also more seriously affected than other banks by the PRA's capital exercise as a whole.

106. Mr Bailey explained why Co-op Bank was so particularly affected by the regulator's actions:

The issue was we felt that within the existing standards there were practices that were leaning towards underproviding, i.e. not looking at questions on a more forward-looking basis, such as refinancing risk.

179

He described Co-op as having taken a "looser" approach towards provisioning than other banks, which was "indeed looser than the standards we felt they should have taken".[180] This appears consistent with the picture painted in Sir Christopher Kelly's report, of a risk management approach with "deficiencies in all three lines of defence" which "had severe consequences for the Bank, and ultimately underpinned much of the capital problem".[181]

107. Mr Bailey told the Committee that particular problems were uncovered in the commercial loan book brought over from Britannia. Describing the PRA's work on these assets, he said:

182

Expanding on his comments to the Committee that the Britannia assets had been a significant contributory factor to the weakness in Co-op Bank's capital position, Mr Bailey said in a letter to the Committee:

183

108. The PRA's capital exercise focused on expected losses over the coming three-year period. Of the impairments actually reported by Co-op Bank over 2012 and the first half of 2013, Mr Bailey said:

184

Given the figures provided in Mr Bailey's letter, this implied that approximately £550 million—"well over half"—of the losses over 2012 and the first half of 2013 originated from Britannia assets.[185] By implication, this left roughly £420 million attributable to the pre-merger Co-op Bank. Asked more broadly where primary responsibility for the financial collapse of Co-op Bank lay, Mr Bailey said: "I think more of the responsibility for the embedded problems goes back to Britannia".[186]

109. The former management of Britannia queried the culpability of the Britannia assets for Co-op's financial troubles. They have raised four main points.

110. First, Neville Richardson, former Britannia Chief Executive, has said that impairments relating to Britannia assets account for only a minority of Co-op Bank's total losses over 2012 and 2013, citing the figure of 27 per cent—though clearly this is still a very significant figure.[187] Evidence to this Committee from Andrew Bailey suggests that, of losses reported up to mid-2013, Britannia impairments accounted for around a third.[188]

111. Second, Mr Richardson has pointed out that "these are not yet actual losses, but provisions against potential losses".[189] Former members of the Britannia board agreed, telling the Committee that "it is essential to draw the distinction between […] impaired lending, provisions and actual cash losses", adding:

190

112. The International Accounting Standards Committee describes the conditions that must be met for a loan to be impaired:

191

In contrast, a cash write-off—rather than being an estimation of the effect on future cash flows from the asset—is made only when it is deemed finally that no more value will be recovered from the asset. Co-op Bank described its process for writing off assets in its 2013 Annual Report:

192

113. Mr Bailey agreed that the impairments may yet be reversed:

193

Co-op Bank's Interim Financial Report 2014 revealed that £86.7 million of Co-op Bank's allowances for losses on loans and advances had in fact been recovered over the first half of 2014. They also showed, however, that £104.6 million of allowances previously made for losses had been written off entirely over the period.[194]

114. Third, the former Britannia management have queried why the Britannia assets are being impaired so heavily so long after origination. Mr Richardson told the Committee:

195

Rodney Baker-Bates similarly commented that "[l]oan books generally do not function that way. If you make a poor loan […] it is fairly obvious in the first two or three years".[196]

115. Mr Richardson, like Mr Marks, appeared to place more of the blame for Britannia's heightened impairments on the actions of the regulator, telling the Committee that "of those [losses] that are attributed to Britannia, much has come about […], very importantly, because of regulatory change in the way that provisions are being required".[197]

116. Mr Richardson also suggested that Britannia-related losses had come about because of "the way in which the businesses have been run".[198] The former Britannia board agreed, telling the Committee that it was "difficult not to conclude" that the "management stretch" at Co-op from mid-2011 was "a contributing factor" to the performance of the loan book.[199] The Kelly Report acknowledged that Co-op Bank's management had been over-burdened following the commencement of the Verde process:

200

Sir Christopher does not, however, consider that this was a significant contributor to the capital shortfall, noting:

201

117. This third contention of the former management of Britannia points to a broader question, of why Co-op's losses—including those on the Britannia book—have emerged so late in the banking cycle compared to those of other banks (see Table 1). Andrew Bailey pointed to two reasons:

202

Mr Bailey added: "We have been on a path to deliver better regulation, as you know, and a big part of that has been to improve the capacity and the technology to conduct things like stress tests […] That is what we have done since the middle of 2011 and, although you may say, 'Here we are in early 2014', it has been a very substantial investment on our part."[203]

118. Mr Bailey told us that he had in fact held suspicions about vulnerabilities arising from the Britannia book prior to the asset quality review and stress testing on Co-op. He said that, in mid-2011, he "had a view—and the supervisors had sympathy with the view—that there was an inherited problem in Britannia";[204] he expressed this view to Co-op's management at a meeting in July 2011, telling Peter Marks, Paul Flowers and Barry Tootell that, in his opinion, "Britannia would have failed had it not been for the Co-op".[205] Mr Bailey told the Committee why he was of this opinion:

Britannia was one of the building societies in 2008-09 that was in trouble. There was a group of them. Bear in mind that this merger [with Co-op] happened over a year between summer 2008 and summer 2009, the most febrile period in the whole of the financial crisis […].

206

Providing more detail on the particular "trouble" at Britannia, Mr Bailey told us:

207

Mr Bailey's view that Britannia would have failed without a merger also related to its ability to fund itself. Mr Bailey told the Committee:

208

Mr Bailey noted that he was "not a supervisor in those days", however, and that while he suspected that there were problems with the Britannia book, the regulator "had not done the detailed asset quality review work […] that has been done subsequently or indeed the stress test" to verify these suspicions.[209]

119. The regulator's late development of stress-testing tools did not, however, in Mr Bailey's view, exculpate individual banks from failing properly to manage their impairments. Asked whether it was reasonable for the board of Co-op to suggest that they had no real awareness of the extent of the capital problem before informed of it by the regulator, Mr Bailey replied:

210

120. Some witnesses have queried the extent to which Co-op took a "different approach" to its impairments. Mr Richardson pointed out that the Britannia assets had been subject to a number of annual external audits since they formed part of Co-op Bank's accounts.[211] For over thirty years, Co-op Bank's external auditor had been KPMG.[212] Andrew Walker, KPMG's lead audit partner for Co-op Bank, told the Committee:

213

121. Mr Bailey's assertions touch on the fourth contention of the former management of Britannia—that Britannia would have survived as a standalone firm. Former members of the Britannia board said in a letter to the Committee:

214

The former Britannia board also rejected Mr Bailey's account of problems at Britannia in 2008/09, saying:

We are not aware of any evidence of conversations or correspondence with Regulators or others at the time of the lengthy merger discussions with Co-op which indicated that Britannia was anything other than a going concern. It was trading effectively with customers, suppliers and the markets in what were extreme financial conditions. […]

215

122. Clive Adamson told the Committee that he did not believe that the FSA's analysis of the Britannia merger, performed in 2009, was flawed:

[O]ur stress test approach and our capital framework approach […] did suggest that under stress—and it is not a forecast it was under stress—the core tier 1 capital position could fall to 4.3 per cent […]

[J]ust to indicate, the outcome for the Co-op by June 2013, the latest set of results, shows that its core tier 1 capital position fell to 4.5 per cent. In other words the stresses did materialise.

216

Disclosures from June 2013 show Co-op Bank's core tier 1 capital falling to 4.9 per cent, and its common equity tier 1 ratio falling to 3.2 per cent. The PRA's capital exercise, however—the exercise which revealed Co-op Bank's £1.5 billion capital shortfall—looked three years ahead, and so accounted not only for losses experienced up to June 2013, but also for losses expected in the future.[217]

123. Expanding further on the capital framework in place at the time, Mr Adamson said:

218

Britannia's Tier 1 capital resources stood at £1,158 million at the end of 2008—a Tier 1 ratio of 10.0 per cent. Other things being equal, £550 million of impairment losses would have brought this figure down to £608 million—a 5.3 per cent Tier 1 ratio, which would have been below the FSA's stressed minimum requirement of 6 per cent.

124. A very significant factor in Co-op Bank's financial collapse was the emergence of substantial impairments on loans over 2012 and 2013, primarily in its commercial real estate book. The majority of these loan impairments—around £550 million—relate to assets acquired through the Britannia merger. Impairments of well over £400 million have also arisen on assets originated by Co-op Bank itself.

125. Attempts have been made to paint Co-op Bank's impairment losses as the result of a shift in the regulatory goalposts. The Committee does not agree. The PRA's capital exercise applied to a number of banks, and only Co-op Bank was so badly affected. Co-op Bank's impairment losses were primarily the result of its own, and Britannia's own, poor-quality lending. The late emergence of these losses appears to have been due to Co-op Bank's comparatively "loose" approach to recording impairments, which was uncovered only once the FSA began its capital exercise in late 2012.

126. Co-op Bank's approach to recording its impairments in the years running up to 2013 was described by Andrew Bailey as "looser" than the rest of the industry. This should have been clear to Co-op Bank's management—to all those responsible for risk and accounting, including the board, relevant executives and committees. It should also have been apparent to Co-op Bank's auditor—KPMG—and to the regulator—for the period in question, the FSA.

127. The Committee is surprised that, in spite of the evidence it has heard, Co-op Bank's former auditors, KPMG, maintain that Co-op Bank was not an outlier in terms of its impairments. The FRC's inquiry into the approval and audit of Co-op Bank's financial statements should determine precisely how Co-op Bank's approach to recording impairments differed to that of other banks, and why KPMG apparently failed to uncover this. The independent inquiry into events at Co-op Bank should also look closely at the shortcomings of the bank's auditor, KPMG, and its apparent failure to ascertain the extent of the impairments. In so doing, the inquiry should look to see if any shortcomings are unique to the KPMG relationship with Co-op.

128. The PRA—the FSA's successor body as prudential regulator—admits that, with better supervisory tools, Co-op Bank's problems would have been uncovered by the FSA sooner. It was the development of these tools—as part of the transition to the new approach to regulation in which the FSA and now the PRA have been engaged—that led to Co-op Bank's impairment losses being revealed. The independent inquiry into the events at Co-op Bank should consider whether the FSA could or should have developed better supervisory tools earlier, and hence uncovered Co-op Bank's impairments sooner. The inquiry should also consider whether Co-op Bank's impairment profile—which appears to have differed from that of other banks throughout the financial crisis—should have led the regulator to inspect it more closely prior to 2012.

129. Notwithstanding any shortcomings in the respective oversight roles played by the auditor and the regulator that may be uncovered by the other inquiries, banks—in this case the Co-op Bank—bear primary responsibility for their own prudent management.

130. The losses emanating from Britannia stemmed predominantly from its commercial loan book. The due diligence performed on this book has proved to have been totally inadequate. KPMG's initial due diligence was based on incomplete information. Further due diligence, which KPMG recommended be performed, was carried out by Co-op Bank itself. Co-op Bank's work has been described by Sir Christopher Kelly as "cursory" and "limited". The provisions against future losses, made on the basis of the due diligence, were far too low.

131. The Committee is surprised that the additional due diligence—a crucial piece of work—was allowed to be performed to such a low standard. KPMG should have given clear guidance to Co-op Bank about the standard required. The Committee is also surprised that, despite recommending the additional due diligence, KPMG did not scrutinise it once complete. If KPMG considered it outside its remit to examine Co-op Bank's own due diligence, it could still have given particular attention to the inherited Britannia assets in future annual audits; the FRC investigation should examine whether or not KPMG did so.

132. Given the evidence it has heard, the Committee is very surprised by JPMC's statement to the Co-op Bank board at the time of the merger that the Britannia due diligence "exceeded that normally undertaken for listed companies". This is not reassuring about the typical quality of professional advisory work, particularly given the substantial sums often involved—KPMG and JPMC received £1.3 million and £7 million—and the important advice and guidance they provided on the Britannia transaction. The Committee expects the independent inquiry into the events at Co-op Bank to examine whether the work provided by KPMG and JPMC met a reasonable standard, in substance as well as form.

133. The FSA performed its own analysis of the Britannia acquisition at the time of the merger in 2009. This projected that, under stressed conditions, the combined entity's Core Tier 1 capital ratio could fall to 4.3 percent, marginally above the regulatory minimum of 4 per cent in place at the time. Co-op Bank's losses up to June 2013 reduced its capital ratio to 4.9 per cent—roughly the level the FSA had projected. But the capital shortfall revealed by the PRA reflected not just actual losses, but also the vulnerability of the Britannia assets to future impairment. It is not clear that the FSA's analysis on the merger took this additional risk into account. The independent inquiry into the events at Co-op Bank should examine why the FSA apparently failed to account for the prudential risks of the Britannia merger that have since materialised.

134. Co-op Bank sought the merger with Britannia in part because of the latter's large network of branches. But—as was clear from the work of the external advisors at the time—the merger also brought an immediate dilution of Co-op members' interests in terms of net assets, profits and dividends, as well as an exposure to higher-risk lending and an increased reliance on wholesale funding. Even without the benefit of hindsight, therefore, it is clear that the merger with Britannia exposed Co-op Bank to considerable new risks yet carried comparatively modest benefits. The commercial judgement behind the decision to proceed with the transaction, made by Co-op Bank on the basis of advice from JP Morgan Cazenove, appears questionable.

135. Andrew Bailey has said that Britannia would have failed had it not merged with Co-op Bank in 2009. The former management of Britannia rejects this, saying that the merger was not a rescue. There is no way to know for certain what would have transpired without the merger, but the evidence appears to support Mr Bailey's view. In particular, the impairments of £550 million now evident from Britannia would probably have been large enough to bring it down as a standalone firm, given the size of its Tier 1 capital base at merger and the capital requirements in place even in 2008. In addition, without the prospect of the merger, Britannia might well have found it difficult to fund itself had the problems with its balance sheet been perceived.

136. Co-op Bank's impairments are as yet only provisions, and not cash write-offs. The distressed loans might yet perform better than expected. But impairments can only be made when there is evidence of a permanent loss of value—a loss which is expected to be made unless conditions improve. The possibility of better performance in no way detracts from the seriousness of the impairments and their effect on the balance sheet. Statements by the former management of Britannia, drawing a distinction between impaired lending and cash write-offs, suggest that they continue to deny the seriousness of the impairments. They should instead accept responsibility for originating the distressed assets.

Conduct redress

137. Over 2012 and 2013, Co-op Bank set aside provisions of £562m to cover potential conduct redress claims. This comprised £253m in provisions for PPI, £114m for other mortgage products, £110m for interest refunds relating to the Consumer Credit Act, £33m for interest rate swaps and £26m for third party insurance products.[219]

138. As described earlier, the PRA's stress testing exercise considered banks' potential future losses from conduct redress claims, as well as loan impairments. Some of the losses reported over 2013 were therefore included in the £1.5 billion shortfall figure. When Co-op Bank announced in October 2013 that it was increasing its total conduct cost provisions by £100-105 million, it also announced:

220

139. However, press reports in March 2014 revealed that Co-op Bank had uncovered £400 million of additional conduct costs, which would require an additional capital injection above the £1.5 billion previously mandated by the PRA. Reports also suggested that this figure was determined just weeks before the publication of the bank's 2013 annual report, since this was the first opportunity the bank's new management had had to review the treatment of its customers.[221] Andrew Bailey had previously told Co-op Bank in 2011 that its handling of PPI complaints was poor—something he noted was particularly poor for a bank that "purported to take a more ethical approach".[222]

140. On PPI provisions in particular, Sir Christopher Kelly concluded:

223

141. Co-op Bank's consumer redress losses are large and damaging for an institution of its size. Combined with its other losses, they pushed Co-op Bank to the brink. Co-op Bank is not alone in having to set aside large sums to pay for past misconduct. However, such misconduct is particularly unacceptable in a bank that trades on its ethical character.

Banking IT platform replacement

142. Another key contribution to Co-op Bank's financial difficulties was the £298m write-down in the value of its investment in a new banking IT platform.[224]

143. The Kelly report looks in detail at the failed replacement of Co-op's banking platform. Prior to the Britannia merger, Co-op Bank had embarked on a wholesale replacement of its core banking IT platform, originally built in the 1970s. This was, in Sir Christopher's words, an "ambitious" undertaking—something which no UK full-service bank had successfully achieved.[225]

144. Following the Britannia merger, the scope of the programme was increased to include Britannia systems. In the process, Sir Christopher concludes that the risk of the programme was also increased:

Received wisdom in bank mergers is that the safest approach is to migrate one business onto the platform of the other. It is a brave organisation which attempts to migrate both merging entities onto a brand new platform.

226

145. The Kelly Report describes a "litany of deficiencies" in the way the programme was implemented following the Britannia merger: it enjoyed neither stable executive sponsorship nor consistent day-to-day leadership; the bank lacked the capability necessary to implement such a complex and high-risk programme; communication and co-ordination between different parts of the business involved in the reprogramming was weak; the bank did too little to limit complexity; the scheduling and sequencing of releases changed frequently; and there was a disregard for the importance of detailed work scheduling.[227] In addition, the expected costs of the programme escalated consistently, rising from £184 million in 2008 to £460 million in 2010.[228]

146. After Co-op Bank won the Verde branches, it began to plan for the migration of Verde customers onto the new platform. But, as described earlier, due diligence in early 2012 identified significant costing errors: the programme as a whole would cost £1.8 billion, rather than £0.8 billion as originally thought.[229]

147. As described earlier, following the discovery of these costing errors, Co-op Bank changed its plans and aimed instead to move its customers onto the Verde IT system. In consequence, Co-op Bank's IT programme—on which £349 million had already been invested—was put on hold. The programme was paused in a way that would allow it to be restarted should Verde fall through, although Sir Christopher notes that "[i]n practice, restarting IT programmes of this kind, once paused for any significant time, can be very difficult because teams and knowledge disperse".[230]

148. In the event, the value of Co-op Bank's investment in the banking IT platform programme was written down by £150 million in the 2012 Financial Statements, which reported that "the impact of the continuing and prolonged economic downturn on the future value stream from the new banking platform now indicates that the carrying value should be reduced".[231] Sir Christopher observes that this write-down, of less than half the full investment in the programme, implied that the programme was still thought to carry some value.[232] Following the collapse of the Verde deal in April 2013, however, Co-op Bank decided to cancel the programme entirely.[233] A further write-down of £148 million was recorded in the bank's 2013 interim report. The bank's 2013 annual report explained that the IT programme was "inconsistent with the Bank's simplified strategy going forward", and that the bank's revised IT strategy would be "focused on incremental improvements in the existing platform rather than wholesale replacement".[234]

149. Some who gave evidence to the Kelly Report claimed that the IT programme could have been concluded successfully had it not been put on hold due to Verde. Sir Christopher concludes that this is a "misconception":

235

150. Evidence to this Committee supports a view of a firm incapable of transforming its IT successfully. Peter Marks confirmed that the integration of Co-op and Britannia systems "had not been fully completed" by 2011.[236] Verde compounded the difficulty of this task, and David Davies was sceptical that Co-op's management "which had not been successful in the integration of the Britannia branches on to the Co-op systems, could do something of this nature".[237] Andrew Bailey, meanwhile, expressed his surprise at the scale of the losses, which he said were "hugely larger than anybody could have expected":

238

151. The extent of the write-off was due to the circumstances of the programme. But Sir Christopher notes that the timing of the programme's effect on Co-op Bank's capital position was influenced by the accounting treatment that Co-op Bank adopted for it in October 2010. Co-op Bank chose to finance the programme through a separate service company—Co-operative Financial Services Management Services—which was owned by the Co-operative Banking Group. In doing so, Co-op Bank ensured that programme costs would have no effect on its capital resources during development, and would only be deducted from regulatory capital gradually once the system was operational. Had the bank funded the programme itself, costs would have been deducted against capital as the programme was developed. The consequence of this accounting treatment was that Co-op Bank recorded no capital deductions from the programme over the first years of development, and then had its capital reduced by almost the full amount of the investment over a period of just six months when the programme was cancelled.[239]

152. Sir Christopher notes that there is some uncertainty over whether the accounting treatment adopted for the programme was ever pointed out to the regulator:

240

153. Co-op Bank's banking IT system had been in need of replacement for many years. The prospective acquisition of Verde only made this need more acute. But the bank, through a combination of over-ambition and poor management, failed to deliver a replacement. Following over five years of delays and cost increases, the programme was cancelled, leaving the bank with its original platform still in place and a £300 million deduction from its capital.

154. There are signs that difficulties with the programme were accentuated by the Britannia merger and the Verde deal. But the evidence suggests that these deals did not cause the problem: the root cause was a management team incapable both of delivering the necessary IT transformation and of realising its own limitations.

155. While it had no effect on the extent of the write-off, the accounting treatment that Co-op Bank adopted for the IT programme had a significant influence on the timing of the impact on the bank's capital position. One method of accounting—funding the programme directly through the bank—would have ensured that the costs of the programme were deducted from Co-op Bank's capital position as they were incurred. The method adopted—financing the programme through a service company owned by the bank—meant that the full cost was recorded over a six month period as the programme was paused and then cancelled. The FRC should consider as part of its investigation whether this accounting treatment was appropriate. The independent inquiry into the events at Co-op Bank should establish whether this accounting treatment was brought to the attention of the FSA, and whether the FSA should have foreseen and acted on its consequences.

Direct effect of the Verde transaction of Co-op Bank's financial position

156. The Kelly Report considers the direct effect of the Verde transaction on Co-op Bank's capital shortfall. It concludes:

241

The indirect impact of Verde was "far more significant", Sir Christopher says, noting that the negotiations were a significant distraction from business as usual:

242

However, Sir Christopher concludes:

Most of the root causes of the bank's capital problems were in place before the transaction was contemplated. The likelihood is that the bank would still have a significant capital shortfall had the Verde transaction never been attempted. […]

243

Reported losses versus the capital shortfall, and other factors in Co-op Bank's financial collapse

157. Co-op Bank's financial collapse is described not just by its losses reported to date, but by the resulting shortfall against regulatory capital requirements that increased at the same time that Co-op's losses emerged. As Sir Christopher Kelly reported:

244

158. One measure of the capital shortfall has already been described—the PRA determined in June 2013 that Co-op Bank was £1.5 billion short of the 7 per cent Common Equity Tier 1 ratio set out in Basel III, once expected future losses over the a three year period had been taken into account.

159. Sir Christopher's comments about increasing capital requirements refer to a different, but related measure—a £1.9 billion shortfall against the total capital guidance issued by the PRA to Co-op Bank. This total guidance comprised 'Individual Capital Guidance'—a minimum level of capital which Co-op Bank needed to maintain at all times—and a 'Capital Planning Buffer'—a buffer on top of this minimum requirement to help to ensure that Co-op Bank maintained this minimum level even in times of stress.

160. Sir Christopher notes that a "significant proportion" of Co-op Bank's £1.9 billion shortfall against this guidance was due to the size of its Capital Planning Buffer, which the PRA increased in January 2013.[245] This increase reflected, among other issues:

246

Indeed, Andrew Bailey said in a letter to the Committee in September 2013:

I [previously] noted concerns that the Britannia assets had been a significant contributory factor to the weakness in Co-op Bank's current capital position. […]

[M]y concern was not just that the former Britannia assets had contributed a significant proportion of Co-op Bank's loan losses but that the nature of those assets meant that they were likely to lead to further impairment. The former Britannia assets were those on the bank's balance sheet that were most vulnerable to further stress. This was consistent with our assessment of the capital shortfall at Co-op Bank.

[…]

247

161. Sir Christopher explains that the PRA also increased Co-op Bank's Individual Capital Guidance, albeit by a much smaller amount, in January 2013.[248] This reflected a number of factors, including Co-op Bank's "significant exposure" to concentration risk, particularly in its corporate lending book, and its "inadequate" operational risk framework.[249]

162. While part of Co-op Bank's capital shortfall therefore reflected increased regulatory requirements rather than reported losses, this did not mean, Sir Christopher said, that Co-op Bank's near-collapse was the result of a shift in the regulatory goal-posts:

250

The collapse of the Verde deal

163. Co-op Bank was first made aware by the regulator that it had a significant capital problem in late 2012 and initial figures were put around this in January 2013.[251] Sir Christopher Kelly notes that the large increase in Co-op Bank's capital requirements in January 2013:

252

164. Following the heightened regulatory requirements in 2013, 'Project Pennine' was initiated. Barry Tootell described this project to the Committee:

253

165. However, Barry Tootell told the Committee that, over February and March, he came to the conclusion that "we were not going to put sufficient remediating actions in place to address the future capital requirements", and on that basis he concluded that Co-op Bank should not pursue the Verde transaction:[254]

255

Co-op formally withdrew from the deal on 24 April 2013, citing "the impact of the current economic environment, the worsened outlook for economic growth and the increasing regulatory requirements on the financial services sector in general", which meant that it was "not in the best interests of the Group's members to proceed further".[256]

Conclusions

166. A combination of financial losses and increased regulatory capital requirements together led Co-op Bank to develop a significant capital shortfall. Co-op Bank's loan impairment losses, IT write-offs and conduct redress costs caused a serious depletion of its capital resources. While regulatory adjustments applied to all banks, the increased capital requirements on Co-op Bank were particularly large. This reflected weaknesses particular to Co-op Bank—the vulnerability of its Britannia loanbook to future impairment, high concentration risk in its corporate lending and a poor operational risk framework.

167. The collapse in Co-op Bank's financial position prompted its withdrawal from the Verde transaction. Explaining its withdrawal from the process in April 2013, Co-op Bank spoke obliquely of "the impact of the current economic environment, the worsened outlook for economic growth and the increasing regulatory requirements on the financial services sector in general". However, Co-op Bank's former Chief Executive, Barry Tootell, gave a franker admission: he told the Committee clearly that he recommended to Co-op Bank's board, and to group Chief Executive Peter Marks, that Co-op should not pursue the transaction because it lacked the capital strength to do so.

168. There is reason to think that the frailty of Co-op Bank's capital position could have been discovered sooner—specifically, if the bank had monitored its loan book and its treatment of customers more effectively, and if it had accounted for its banking IT programme in a different way. Had Co-op Bank's resulting capital shortfall been uncovered earlier, it is likely that the bank would not have progressed so far with Verde. As it was, the rapid and late emergence of the capital problem led to Co-op's withdrawal from the Verde process at a relatively late stage. The Committee recommends in paragraphs 127, 128 and 155 that the FRC investigation and the independent inquiry into the events at Co-op Bank consider the role of KPMG and the FSA in relation to the late emergence of loan impairment and IT losses. On the basis of these findings, the independent inquiry into the events at Co-op Bank should also form a view on whether Co-op's Verde bid could or should have been halted sooner.

169. Once Co-op Bank's capital shortfall became clear in January 2013, the bank might have been expected to withdraw immediately from the Verde deal. The Committee shares Sir Christopher Kelly's surprise that it did not—instead, Co-op persevered with the deal until late April. It may be that Co-op Bank had confidence that 'Project Pennine'—a plan to bolster Co-op Bank's capital position through disposal of assets—would put it back on a secure financial footing; if so, this confidence proved to be misplaced.

170. The board and management of Britannia are responsible for having originated the majority of Co-op Bank's distressed assets, as well as assets against which Co-op Bank has been forced to hold substantial protective capital. Co-op Bank itself is responsible in a number of other respects, including its inadequate due diligence on the Britannia merger. Co-op Bank originated loans which have suffered impairment. Legacy conduct issues relate predominantly to past actions by Co-op Bank. Responsibility for the mismanagement of Co-op's banking IT platform upgrade, while complicated by the Britannia merger, lies squarely with Co-op Bank. The former board and management of Co-op Bank and Britannia bear primary responsibility for the bank's resulting financial crisis.

132 Qq 540, 547 Back

133 Qq 1096-1098 Back

134 Q 1218 Back

135 Q 992 Back

136 JP Morgan Cazenove (PV 13) page 274 Back

137 Ibid. page 267 Back

138 David Anderson (PV 10) Back

139 KPMG (PV 13) page 62 Back

140 KPMG (PV 13) page 58 Back

141 Q 1137 Back

142 Q 1214 Back

143 Q 1043 Back