Co-op plight and bank resolution

Since my previous blog on the subject, Co-operative Bank has been downgraded again by Moody’s, this time to Caa1. Organisations with this credit rating, deep into speculative grade, have a history of  defaults, with 27% failing to meet their financial obligations within three years of having the rating.

The prognosis for the Co-op depends chiefly on two factors. Firstly, whether the junior bondholders will agree to exchange their interest bearing bonds for shares in the bank, in the full knowledge that they are unlikely to see any dividends for many years. They will need to be convinced that the bank’s sole existing shareholder, the Co-op Group, will be taking more losses than the £500 million that they are on the hook for.  They will also need to believe that the proposed bail-in is the best of a bad bunch – i.e. that they would be even worse off if the bank was declared insolvent and liquidated.

Secondly, the purchasers of the Co-op’s insurance businesses will need to stump up the original  £1 billion asking price and resist the temptation to negotiate a lower amount now that they know the owner is absolutely desperate to sell.  Neither of these is a certainty, and with the Co-op Group unlikely to sell further business units like its supermarkets, travel agents or funeral parlours to rescue its financial services division, and with the government even less likely to stump up for a bail-out, the only other option appears to be a “resolution”. So I thought you might appreciate a timely reminder of how the UK bank resolution process currently works, as well as a look forward to how things may change in the future.

Under the current legislation of the Banking Act 2009, failing credit unions and small banks are subject to the Bank Insolvency Procedure (BIP).  This means that banking operations cease immediately, with insured depositors compensated by the Financial Services Compensation Scheme (FSCS), while the remaining depositors and bondholders await the proceeds of insolvency. One recent example is the Southsea Mortgage and Investment Co which failed with assets of £7 million in June 2011 and is currently being liquidated.

For larger banks, where suddenly closing the doors and switching off the cash points could be more problematic, the Bank Administration Procedure (BAP) is used. In this case, insured depositors such as individuals and small businesses owed less than £85,000 have their accounts transferred to another financial institution, and the failed bank is kept partly operational to service those customers and keep the branches open. The other institution may be a bridge bank owned by the Bank of England if no willing purchaser can be found at an acceptable price at short notice. Larger depositors, including local authorities, and bondholders will have to wait for a partial payout from the insolvency process.  They may also receive compensation from the FSCS where it can be shown that they have suffered  greater losses arising from the transfer of the retail deposits.

BAP is the resolution process most likely to be applied to the £50 billion Co-operative Bank, if it comes to it. The only UK example to date is Dunfermline Building Society which underwent a similar administration procedure in 2009 when it failed with assets of £3.3 billion, although due to the different creditor ranking within building societies, wholesale deposits were also transferred at no loss in that case.

A third resolution tool applies to the largest, most complex banks, where the above measures may be insufficient to maintain financial stability.  Here, the Bank of England can arrange a compulsory acquisition of the bank from its shareholders, with compensation (which could well be zero) determined by an independent valuer.  There need be no immediate impact on depositors and other creditors, although anything is possible under this scenario, with the eventual aim being a sale back to the private sector. This is broadly what happened to the £100 billion Northern Rock under emergency legislation in 2008, although advances in regulation and preparation (e.g. living wills), let alone the changed political landscape, make it unlikely that any except the very largest banks would be treated in this way now.

All of the above processes leave the taxpayer at some risk, as the government stands behind both the FSCS and the Bank of England.  Plans are therefore in place, at both a national and European level, to enhance protection for the taxpayer at the expense of large depositors and bondholders. As a result of the Independent Commission on Banking’s report, legislation is now before the UK Parliament to place uninsured depositors like local authorities and other creditors below FSCS-insured deposits in the creditor hierarchy, removing the need for compensation to be paid when retail accounts are transferred out of a failing bank.  This will also remove the special arrangements for building societies.

European proposals on banking rescues announced last month will require national regulators to bail-in creditors in order of seniority until their losses reach at least 8 percent of the distressed bank’s liabilities, before any government money can be injected.  Insured retail and small business  deposits, interbank lending with a maturity of less than one week and secured debt such as covered bonds would all be exempt from the bail-in. This could leave local authority deposits as one of the few categories able to take losses. For example, if unsecured bonds and wholesale deposits make up just 20% of the balance sheet, they will need to take a haircut of 40% to write down 8% of total liabilities.

Governments can then contribute up to 5 percent of the failing bank’s liabilities. If further funds are required, these must come from deeper haircuts on unsecured creditors. Under the proposals, it would be illegal for any more government money to be injected until bondholders and wholesale depositors were completely wiped out.

There are already some precedents for this type of bail-in and resolution process in Europe, such as when the un-guaranteed depositors in Copenhagen-based Amagerbanken took losses of 41% in February 2011. Resolution of the £3.5 billion Danish bank was conducted over the weekend, with the branches and electronic banking systems re-opening as usual on Monday morning.  A few months later, creditors of local competitor Fjordbank Mors, including depositors with accounts exceeding €100,000, suffered losses of 26%.  More recently, the largest depositors in the Bank of Cyprus have had 37.5% of their money converted into shares and a further 22.5% held in a buffer for possible conversion at a later date.  In that case the money was used to shore up the government, rather than the bank, but it all goes to show what is politically possible in this brave new world.

With any luck, Co-operative Bank’s new management will be able to pull off the rescue, saving both national and local taxpayers from contributing towards its loss making commercial property loan portfolio.  But hoping for the best should always be combined with preparing for the worst.

David Green is Client Director at Arlingclose Limited. This is the writer’s personal opinion and does not constitute investment advice.