7 Events following the collapse of
Verde and the emergence of the capital shortfall
281. This section summarises developments involving
Co-op Bank and the Lloyds Banking Group divestment since the revelation
of Co-op Bank's capital shortfall in June 2013. It also considers
whether the case of Co-op Bank provides any lessons for the mutual
model.
Recapitalisation and changes
to governance
282. Following the revelation of the capital shortfall,
significant changes were made to Co-op Bank's governance. A
number of new members with considerable banking experience were
appointed to the Board from May to October 2013, including a new
Chairman, Richard Pym, former Chief Executive of Alliance and
Leicester plc, and a new Chief Executive, Niall Booker, formerly
of HSBC and with over 30 years' experience in retail and corporate
banking. Barry Tootell and Paul Flowers resigned in May and June
2013 respectively. Peter Marks retired in May 2013, as had been
previously arranged in 2012. Len Wardle resigned in November 2013.
By December 2013, the majority of Co-op Bank's directors who had
been in place at the start of the year, including all of those
from the Co-op Group board, had resigned.[478]
Co-op Group retains the power, however, to appoint two members
to the Co-op Bank board.[479]
283. Co-op Bank's new management team set about designing
a recapitalisation plan. Initial plans were drawn up in June 2013
and, following lengthy negotiations, a rescue was finally agreed
between Co-op Bank, retail investor groups and the regulators
in November 2013.[480]
The plan, implemented in December 2013, saw large numbers of retail
bondholders written down in a 'bail-in', an injection of funds
by two large hedge funds, and the group's stake in the bank reduced
to 30 per cent.[481]
Additional conduct redress losses uncovered in March 2014 required
an additional capital injection of £400m by institutional
investors in May 2014, which reduced Co-op Group's stake further
to 20 per cent.[482]
284. Sir Christopher Kelly's report noted:
The new management [of Co-op Bank] have taken
positive steps towards reforming risk governance, including a
reorganisation of reporting lines and some changes in personnel.
Several interviewees told the Review that the Bank has been rebuilding
the Risk Management function almost from scratch.[483]
And, on Co-op Bank's outdated IT, Sir Christopher
said that the new management was "now addressing a number
of issues that should have been dealt with some years ago".[484]
285. Co-op Bank's interim financial report for the
first half of 2014 showed considerable improvements to the bank's
financial position. Compared with the end of 2013, the bank's
Common Equity Tier 1 capital ratio rose from 7.2 per cent to 11.5
per cent, and its liquidity position improved.[485]
The bank's loss before tax—excluding the effects of the
bank's May 2014 capital raising—was £75.8 million,
compared to £844.6 million in the first half of 2013.[486]
Lessons
for the mutual model?
286. Co-op Bank was not itself a mutual firm. But
it was wholly-owned by the mutual Co-operative Group. As such
it shared some of the features of its parent. As has been described,
it was afflicted by the group's governance structure. And, in
common with all mutuals, it had no access to the public equity
markets—its only source of capital was retained earnings,
either from its own business or from other Co-op businesses via
injections from the group.
287. The Committee asked a number of witnesses whether
what happened at Co-op Bank reflected a weakness in the mutual
model, or weaknesses particular to Co-op Group. Witnesses agreed
that the problems in many areas were particular to Co-op. Andrew
Bailey told us:
I think the governance issues were particular
to the Co-op, yes. I do not see those sorts of issues in building
societies.[487]
Lord Myners also believed that the issues he had
uncovered with the wider Co-op Group were "quite specific
to the size and complexity of the Co-op".[488]
David Anderson did not see "a read-across about the constitutional
status", and furthermore felt that the lessons from the case
of Co-op Bank "would probably apply to a proprietary bank
just as much as they would apply to a mutual".[489]
He added:
I think that in every sector there are businesses
that do well and businesses that make mistakes, and I think it
is clear that in this case mistakes have been made. I fundamentally
disagree with anyone who says that undermines the financial mutual
model.[490]
Sir Christopher Kelly prefaced his report by saying:
My comments on governance should not be interpreted
as a criticism of the co-operative model or of co-operative principles
and values, for which I have a great deal of respect. It is the
particular method of governance adopted by the Co-operative Group
and Bank which in my view has manifestly failed, not the cooperative
ideal in general. The current governance structure in the Co-operative
Group, which dates only from 2001, is not the only way of putting
co-operative principles into practice.[491]
288. Indeed most witnesses were supportive of the
mutual model in general, and broadly positive about its future.
Despite a stinging assessment of Co-op Group's governance and
business management over recent years, Lord Myners told us:
I hope we will see more mutuals and I hope we
will see that in financial services and in other areas. It is
a wonderful model for energising people and drawing people together
around a common purpose.[492]
Peter Marks gave a downbeat assessment of the future
of the mutual model in the "high-volume, low-margin"
retail banking market, telling the Committee that "[t]he
cost of regulation has escalated, as have the cost of capital
and the amount of capital that a bank now has to keep in reserve".
This meant it was "going to be difficult going forwards for
a mutual to be a really serious competitor in the retail banking
market".[493]
But other witnesses pointed out that mutual financial firms which
had stuck to the traditional model had fared well over recent
years. David Anderson told us:
I believe that building societies that have stayed
closer to their traditional approach have remained more secure,
and I believe that has turned out to be the best model. That is
evident from those that now remain societies and from what happened
to the societies that demutualised and chose a more leveraged
model. […]
I believe that successful mutuals are a big part
and an important part of our financial landscape and will continue
to be so.[494]
Andrew Bailey agreed:
Some [building societies] essentially hunkered
down—a phrase they tend to use—in this market and
said, "This is really not a business that we can prosper
in, but we are here for the long run because we are mutuals".
I think they can do this because a mutual can exist on a lower
rate of return than an institution in the commercial sector. It
is shielded in that sense. They took that strategy, and they are
here today and doing pretty well.[495]
This contrasts with the example of Britannia, which,
as Mr Bailey told us, "expanded [its] lending activities
into outside the traditional prime mortgage market that building
societies occupied".[496]
289. Britannia's expansion outside traditional building
society activity came despite its lack of the necessary risk management
skills and, crucially, the ability to raise capital. A number
of witnesses acknowledged the latter as a key vulnerability of
the mutual model. Lord Myners told us:
[A] conventional PLC can always turn to its shareholders
for a rights issue and can always raise more capital. A mutual
cannot do that and, therefore, a mutual has to be run very conservatively.[497]
He added that this made it "folly in the extreme
for the Co-op even to contemplate acquiring [Verde]".[498]
Peter Marks said that Co-op's inability to raise capital had been
"a major problem with why the bank is where it is".[499]
Mr Bailey agreed that the more generic issues around the position
of mutuals were "all to do with the constraints on raising
[…] core tier 1 capital":
This comes back to the risks that Britannia and
a few others were taking. This restriction on the ability to raise
core tier 1 capital inevitably must have an effect on what risks
they take and the way in which they manage risk. Those two things
must be related.[500]
Mr Bailey noted that the regulator now took a firm's
mutual status into account as part of its day-to-day supervision:
We have a team of supervisors on the building
society side who are specialist building society regulators. They
do not, on the whole, do commercial banks in the broader sense.
What that means is that they do understand many of the particular
challenges. We also have what we call a building society source
book, which is a somewhat bespoke approach towards supervising
building societies.[501]
He also confirmed that this 'source book' was "entirely
new" and "brought in after all these experiences".[502]
290. The problems at Co-op over the last few years
are not an indictment of the mutual model. The problems of Co-op
were, on the whole, particular to Co-op. Other mutual firms have
come through the financial crisis well.
291. The inability easily to raise capital is,
however, a marked vulnerability in the mutual model. The PRA now
claims to take the particular features of mutual firms into account
as part of its approach to supervision. This is an important change
of approach.
The Lloyds divestment
292. Lloyds TSB and HBOS merged at the height
of the financial crisis, amid serious concerns that HBOS would
collapse without some form of external support. In the event,
even this merger proved insufficient—the enlarged banking
group required an injection of £20.5 billion in taxpayer
funds.
293. The merger of these two already-large banking
institutions resulted in a significant concentration in the UK
banking market. In response to the state aid, the Verde divestment
aimed to remove the resulting competitive distortions and inject
some competition back into the market.
294. In its final report in September 2011, the
ICB had recommended that, to have the "best possible chance
of becoming a strong, effective challenger", the entity resulting
from the divestment should have at least a 6 per cent share of
the personal current account (PCA) market.[503]
The ICB's final report set out the reasons behind this:
[T]he entity resulting from the divestiture will
[…] need
to be large enough to exert a competitive constraint on the large
incumbents. Evidence
from the previous decade shows that small banks (below 5 per cent
PCA market share)
on average have grown only slowly, with an average annual growth
in market share
of 0.07 per cent. Banks with a PCA market share of between 5 per
cent and 12 per cent, by contrast,
grew significantly more
quickly, with an average annual growth in market share of
0.34 per cent (although
given the relatively small number of challengers, this number
is drawn
from a small sample). […] With a PCA market share of 4.6
per cent, Verde is on the
borderline of sub-scale banks that have failed to grow significantly
in the past, and is
smaller than most previous challengers over the past decade as
measured by PCA market
share.
A larger entity would benefit from greater economies
of scale, giving it lower cost which could be passed on to customers
in the form of better prices. […]
In addition, there is a significant risk that
Verde's market share will fall further as it may suffer customer
attrition from the divestiture process. […]
Given these factors, there is a real danger that
Verde will fall back into the range of small banks that have not
exerted a strong competitive constraint in the past, if it remains
at its current size.[504]
295. The collapse of Co-op Bank's bid for the
Verde branches dealt a blow to this ambition: the combination
of Verde and Co-op Bank would have met the 6 per cent target—creating
an institution with almost 7 per cent of the PCA market—whereas
Verde alone did not.[505]
Following Co-op Bank's withdrawal from the process, Lloyds announced
that it would embark on its fallback option of an IPO:
The Group now intends to divest Verde through
an Initial Public Offering (IPO), having maintained this option
throughout the process in order to ensure best value for our shareholders
and certainty for our customers and colleagues. […]
The Group continues to make good progress in
the creation of Verde as a stand-alone bank. A strong management
team is in place and we have made good progress in creating segregated
IT systems on the proven Lloyds Banking Group platform and in
building the necessary corporate functions to support front-office
colleagues, branches and operational sites.
Detailed plans are in place for a rebranding
of the business as TSB which will be visible on the High Street
during the summer of this year, at which point the TSB Bank (Verde)
will operate as a separate business within Lloyds Banking Group.[506]
296. The relevant Lloyds branches were rebranded
as TSB on 9 September 2013, and the first tranche of shares was
issued in an IPO on 20 June 2014.[507]
But, as at June 2014, TSB had only a 4.2 per cent share of the
PCA market, still some way short of the 6 per cent the ICB recommended.[508]
Moreover, TSB does not expect to reach the 6 per cent target for
four to five years.[509]
In July 2014, the Competition and Markets Authority (CMA) concluded
that:
TSB has a relatively small size and it is unclear
at this stage what its overall impact on competition will be.[510]
297. The Parliamentary Commission on Banking Standards
published its final report in June 2013, two months after the
collapse of the Verde divestment. The planned divestment of a
number of RBS branches to Santander UK had also collapsed in October
2012.[511] The Commission
concluded in its final report:
Regardless of whether these divestments can be
put back on track, it looks increasingly unlikely that a significant
new challenger bank will soon emerge from them. Additionally,
given the delays in the divestments—which now most likely
will take until at least 2014 to be completed—it will not
be possible to assess whether they have fundamentally altered
competition in the sector until 2017 or 2018 at the earliest.[512]
The Commission suggested a number of steps that should
be taken in addition to the divestments to increase competition
in the UK banking market, including:
· That
the PRA be given a secondary statutory objective to lessen the
risk that it might neglect competition considerations. This was
a concern given the potential for prudential requirements to act
as a barrier to entry and to distort competition between large
incumbent firms and new entrants.[513]
The PRA was subsequently granted such an objective in the Financial
Services (Banking Reform) Act 2013.[514]
· That the FCA
commit to embedding a robust pro-competition culture within itself,
which looked to competition as "a primary mechanism to improve
standards and consumer outcomes". The FCA expressed its commitment
to this aim.[515]
· That the FCA
consult on a requirement to publish a range of statistical measures
to enable consumers to judge the quality of service and price
transparency provided by different banks.[516]
The FCA agreed to publish a call for evidence inviting ideas on
potential indicators of firm and product quality, before deciding
which indicators to take forward.[517]
· That the Competition
and Markets Authority (CMA) carry out a market study of the retail
and SME banking sector. This study was to be completed on a timetable
consistent with making a market investigation reference in respect
of the UK banking market, should the CMA so decide, before the
end of 2015.[518] In
July 2014, the CMA announced its provisional conclusions: that
the SME and PCA markets did not appear to be functioning in the
way it would expect of effective competitive markets, leading
to poorer outcomes for customers and the wider economy. On this
basis, the CMA's provisional decision was that a market investigation
reference should be made in respect of both sectors. Following
consultation, it will announce its final decision later this year.[519]
298. The Commission also welcomed the revised approach
to authorising new entrant banks, announced by the FSA in March
2013, and adopted by its successor regulators thereafter. These
reforms would ensure
that the PRA would require start-up banks to hold proportionately
less capital than major incumbents, that automatic new bank liquidity
requirement premiums would no longer be enforced, and that capital
requirements for rapidly growing new banks would rise gradually,
so that they would not be required to operate on the same basis
as incumbent firms for three to five years. The Commission considered
these reforms "a long overdue correction of the bias against
market entrants, who are, at least initially, unlikely to be of
systemic importance".[520]
The Commission concluded, however, that the implementation of
these reforms would require careful monitoring, and that
"the regulator should report to Parliament on progress in
two years' time".[521]
299. The FSA's barriers to entry review in March
2013 noted that 39 new banks had been authorised by the FSA between
2006 and 2012.[522]
A review by the PRA and FCA in July 2014 on the effect of the
barriers to entry reforms reported:
In the twelve months following the changes, the
PRA authorised five new banks and there has been a substantial
increase in the number of firms discussing the possibility of
becoming a bank with the regulators. In the twelve months to 31
March 2014 the regulators held pre-application meetings with over
25 potential applicants. These firms have a range of different
business models from retail and wholesale banking to FCA-regulated
Payment Services firms who are looking to enter the banking market
and offer deposits and lending to their current client base (including
small SMEs) and others who are proposing to offer a mixture of
SME or mortgage lending funded by retail and SME deposits.
The review found that the new 'mobilisation'
option (where authorisation is granted when a firm has met key
essential elements but with a restriction on their activities
due to some areas still requiring completion) has been helpful
for applicant firms that may previously have faced challenges
in raising capital or investing in expensive IT systems without
the certainty of being authorised. In the twelve months to 31
March 2014, three of the five newly authorised banks used the
mobilisation option, and a number of firms in the pre-application
stage have also shown an interest in this route.
Capital and liquidity requirements for new entrants are now lower
than before, but are set against a requirement for a firm to show
the regulators that it has a clear recovery and resolution plan
in place in the event of it getting into difficulty in the future.
These changes are a real reduction in the barriers to entry, and
now mean that the minimum amount of initial capital required by
a new entrant bank is £1m compared to £5m under the
previous regime.[523]
300. One of the most significant consequences
of Co-op Bank's near-collapse, from a public policy perspective,
was the collapse of Lloyds Banking Group's planned divestment.
Co-op Bank's withdrawal forced Lloyds to resort to its fallback
option of an Initial Public Offering. The result is a new bank—TSB—which,
not having an existing banking presence of its own, consists solely
of the business divested by Lloyds. Accordingly, it has a personal
current account market share not of 7 per cent, but of 4.2 per
cent. There is a risk that a bank of this size might struggle
to grow significantly and to act as a true challenger in the market.
This is not a judgement on TSB or its management, but reflects
an observation of the Independent Commission on Banking that the
entity resulting from Verde should have a market share of at least
6 per cent to have the best chance of becoming an effective challenger
bank.
301. The Verde divestment alone was never likely
to be enough to inject sufficient competition into the UK banking
market, which is the best way of improving consumer outcomes.
The Treasury Committee, repeatedly, and also the Parliamentary
Commission on Banking Standards, have both advocated measures
to increase competition.
302. The Committee welcomes the news that there
has been a substantial recent increase in the number of firms
discussing the possibility of becoming a bank with the regulators.
However, we have yet to see an increase in the number of new entrants.
The regulators will report to Parliament on progress in a year's
time.
478 The Co-operative Bank plc, 'Annual report and accounts 2013',
pages 33-34 Back
479
Sir Christopher Kelly, 'Failings in management and governance',
(30 April 2014), paragraph 13.35 Back
480
The Co-operative Bank plc, 'The Co-operative Group announces Recapitalisation Plan for The Co-operative Bank',
4 November 2013 Back
481
The Co-operative Bank plc, 'Confirmation of scheme sanction',
18 December 2013 Back
482
The Co-operative Bank plc, 'Results of Capital Raising', 28 May
2014; The Guardian, 'Co-op Group stake in bank expected to shrink to 20% after rescue fundraising',
9 May 2014 Back
483
Sir Christopher Kelly, 'Failings in management and governance',
(30 April 2014), paragraph 6.8 Back
484
Ibid. paragraph 14.30 Back
485
The Co-operative Bank plc, Interim Financial Report 2014, (21
August 2014), page 7-8 Back
486
Ibid. page 9 Back
487
Q 1971 Back
488
Oral evidence taken on 7 May 2014, HC (2013-14) 1265, Q 61 Back
489
Q 1035 Back
490
Q 1034 Back
491
Sir Christopher Kelly, 'Failings in management and governance',
(30 April 2014), paragraph 1.6 Back
492
Oral evidence taken on 7 May 2014, HC (2013-14) 1265, Q 61 Back
493
Q 475 Back
494
Qq 1034, 1039 Back
495
Q 1929 Back
496
Q 1927 Back
497
Oral evidence taken on 7 May 2014, HC (2013-14) 1265, Q 46 Back
498
Ibid. Back
499
Q 474 Back
500
Q 1971 Back
501
Q 1972 Back
502
Ibid. Back
503
Independent Commission on Banking, 'Final Report', September 2011,
paragraph 8.25 Back
504
Independent Commission on Banking, 'Final Report', September 2011,
paragraphs 8.22-8.25 Back
505
The Co-operative Group, 'Lloyds Banking Group Announcement', 19
July 2012; Q 1982 Back
506
Lloyds Banking Group, 'Lloyds Banking Group update on EC mandated business disposal (Project Verde)',
24 April 2013 Back
507
Lloyds Banking Group, 'TSB Banking Group plc IPO: Announcement of Offer Price',
20 June 2014 Back
508
TSB Banking Group plc, 'Results for the six months to 30 June 2014',
page 4 Back
509
Reuters, 'Lloyds Bank launches TSB share sale to create new UK lender',
27 May 2014 Back
510
Competition and Markets Authority, 'Personal Current Accounts Market Study Update',
paragraph 2.22 Back
511
Financial Times, 'Santander pulls the plug on RBS deal', 12 October
2012 Back
512
Parliamentary Commission on Banking Standards, 'Changing banking for good',
HC 175-I, paragraph 66 Back
513
Ibid. paragraph 212 Back
514
Financial Services (Banking Reform) Act 2013, Section 130 Back
515
Parliamentary Commission on Banking Standards, 'Changing banking for good',
HC 175-I, paragraph 214 Back
516
Ibid. paragraph 70 Back
517
Financial Conduct Authority, 'The FCA's response to the Parliamentary Commission on Banking Standards',
October 2013, page 33 Back
518
Parliamentary Commission on Banking Standards, 'Changing banking for good',
HC 175-I, paragraph 68 Back
519
Competition and Markets Authority, 'Personal current accounts and small business banking not working well for customers',
18 July 2014 Back
520
Parliamentary Commission on Banking Standards, 'Changing banking for good',
HC 175-I, paragraph 51 Back
521
Ibid. paragraph 52 Back
522
Financial Services Authority, 'A review of requirements for firms entering into or expanding in the banking sector',
March 2013, Annex 2, pages 1-2 Back
523
Prudential Regulation Authority, 'News Release - Prudential Regulation Authority and Financial Conduct Authority publish review of barriers to entry for new banks',
7 July 2014 Back
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