The Co-operative Bank is no longer. What was once an experiment in working class self-help has become the latest victim of rapid changes sweeping the financial sector. It seems unlikely that the ethical values on which the bank was built will survive the transition.
Instead of being a co-operative institution owned and run by its customers, the Co-op is now largely owned by private investors. Its shares will be traded on the stock exchange and will essentially become as any mainstream bank.
How did this bastion of practical socialism fall into the hands of North American hedge funds? To understand this tale, we need to go back to the heady days following the financial crisis. Up until this point, the Co-op had been a relatively stolid institution serving largely working class communities. It was not exciting, but that is how its customers and owners liked it. It was part of the broader Co-op group which provided services such as supermarkets and funerals.
This broader group of businesses traced its origins back to the Rochdale pioneers in the North of England who had founded co-operatives as an alternative to the private businesses offering them over-priced and poor quality goods. The movement had taken off and spread throughout the country. Parts of the co-op movement were actually the engines of many modern business innovations – particularly in the retail sector.
In 2008 the Britannia building society was the second largest mutual society in the UK. Although it had not demutualised, it had sought to be an aggressive competitor in the financial landscape. This had led it to engage in the riskier end of lending in the property market. When the financial crash came, the idea of merging the Co-op and Britannia to create a “super mutual” was proposed.
Politicians were keen on the plan as it would create a larger organisation that would be a viable alternative to the big high street banks. The CEOs of the companies were pleased as it would be a nice line in their CVs. Customers seemed pleased as it would extend their services. This new super mutual was the darling of the financial sector for a short time. It was hailed as an ethical alternative to the naughty high-street banks.
But mergers and acquisitions are often driven by hubris at the top and sure enough, the goodwill went to the heads of some members of the Co-op’s senior management, who seemingly overlooked the negatives when deciding to merge with Britannia. When Lloyds was forced to sell off more than 600 branches to comply with competition law, they saw an opportunity to extend their operations even further. If the Co-op’s bid was successful, they thought, it would become one of the biggest players on the high street.
Trouble in paradise
But behind the scenes, all was not well. After the merger, things began to look a little less rosy. For a start, integrating the IT systems from the Co-op and Britannia proved to be a costly exercise. But the big shock came when it was revealed that a series of bad loans had been secreted away on Britannia’s balance sheets. This only became public knowledge when Moodys downgraded the Co-op’s credit rating to junk status.
The plans to take over the Lloyds branches were dropped. On top of this, the Financial Conduct Authority found the Co-op had a £1.5 billion hole in its balance sheet when it conducted an inquiry into capital ratios on the main high street banks.
While its commercial competitors could go back to shareholders and money markets to fill any gaps, the Co-op was in a tighter spot. It did not have shareholders to hit up or a profitable investment banking operation it could plunder. So instead, senior management concocted a plan whereby bond holders (people who had lent the bank money for a fixed rate of return) would accept a new deal with the bank.
A key feature of the deal was that if the bank went belly up, it would be “bailed in” by the bondholders. This would mean their bonds would be converted into shares of the hypothetically worthless company. The big advantage of this was that the Co-op could guarantee to the government that it would not need to fork out for a potentially costly bail-out. Instead, bondholders would bear the brunt.
Naturally the deal proposed by the Co-op did not thrill many of the bondholders. The small time investors, who owned about £60m worth of bonds, complained about additional risk and potentially lower returns and the bigger investors were annoyed that they were being asked to burden the risks which typically come with being a shareholder without getting the benefit of having a say in how the company is run.
These concerns led the largest bondholders, including two US hedge funds, to refuse the terms on the table. Instead of having bonds that could be bailed in at any time, they demanded shares in the Co-op. And this, eventually, is what they got. The upshot of this weekend’s wrangling is that, ultimately, the Co-operative group will only own 30% of the Co-Op Bank. The remainder will be private.
Ethics out the window?
The management of the Co-op has, as one might expect, given assurances that the changes will not affect the bank’s distinctly “ethical” approach. But the evidence of what happens when a mutual banks goes private casts some doubt on these fine words. Studies suggest that demutualised banks tend to drop their focus on doing good and instead focus on doing well for shareholders.
This was evident when many ex-mutuals became some of the worst offenders in the lead up to the financial crisis. Banks that were formerly co-operatively owned, such as Northern Rock and Bradford and Bingley were dominated by a hard-driving sales culture, and dodgy loan books to match.
This entrepreneurial zeal did not make ex-mutual banks much more successful. Mutually owned banks actually tend to outperform shareholder owned banks and this became apparent when, on the whole, the ex-mutuals became less efficient. When these banks began to cost more to run than they produced, the whole sector became less efficient as a consequence.
If we take the evidence seriously, then the transfer of the Co-op into private hands is likely to make it a less ethical, less well staffed, and less efficient institution. It will also mean customers have less choice and local communities may find increasingly isolated from access to finance.