Co-op finance director insists bank will remain ethical as it moves to share listing to plug £1.5bn black hole

Bondholders to pay the penalty in debt-for-equity swap but no taxpayer funds will be needed

The Co-operative Bank is going public, listing shares on the stock market to plug a £1.5bn black hole in its balance sheet. The bank unveiled a deal with the Prudential Regulation Authority yesterday that will see its bondholders paying the penalty for its disastrous acquisition of Britannia Building Society, which is largely responsible for its struggles.

They will become minority shareholders in a newly listed Co-operative Bank after a debt-for-equity swap.

Both City institutions and about 7,000 individual bondholders, whose investments average around £1,000, will therefore lose their regular interest payments and probably also a significant chunk of their capital when the shares start trading. Small investors in Co-op bonds will, however, be offered financial advice on how best to deal with the loss of income and change in the state in their investment.

They will provide £500m of the Co-op's needs, with a further £500m coming from the proceeds of the Co-operative Group's sale of its insurance and fund management business. The rest will come from the issue of new unsecured loan instruments. As a result of the deal, the taxpayer will not be required to provide any funds to keep the bank from going under.

However, the value of the affected bonds dropped sharply, and Co-op admitted it will also cease interest payments on as many of the bonds as it can with the aim of saving £20m a year.

Gregory Turnbull Schwartz, a bond fund manager with Kames Capital, which has a £29bn fixed interest portfolio, said of the deal: "There are two parts of this that are troubling. One is the idea that bondholders should take losses before owners are wiped out or at least put in the minority.

"The second part is treating individual investors in a bond differently, which is unfair on those who have invested through a mutual fund, many of whom would be of less means than those with the resources to invest individually."

Euan Sutherland, the new Co-operative Group chief executive, said: "We are determined to transform the bank, and this is based on a clear and deliverable plan which draws on the support of all stakeholders."

Richard Pennycook, the group's finance director, also sought to reassure customers that the newly quoted bank would retain its distinctive ethical stance: "When we float the bank, one of the things that will be very important for the minority shareholders are the principles we apply to the bank. They will be true to the spirit of its past.

"The bank has a very loyal following, and one of the challenges for its new management is to make sure we restore the faith that has been there for very many years."

Mr Pennycook argued that the Co-operative Group has in effect been "wiped out" and was pumping in £1bn of its funds to buy a new shareholding rather than walking away. "That will constitute our new shareholding. This is a fresh start," he said.

Co-op, whose problems came to light after its failure to buy the new Verde bank which is being sold by Lloyds under EU mandate, has said it will in future focus on retail and small businesses.

The bank is likely to come to market in October.

Q&A: fallout from the big shake-up

Q Who will be affected by yesterday's move?

In the short term, it will only affect those who bought into the Co-op's preference shares and perpetual subordinated bonds. Some 95 per cent were sold to institutions, but there are around 7,000 small investors who spent an average of less than £1,000 on the bonds. They could be offered new bonds that may cut the value of their holding by more than half.

Q So they've really lost out?

The details are not fully clear of what will be offered in exchange for the bonds so the extent of losses will depend on several factors, including what price investors originally paid for their bonds. The Co-op was quick to point out that most are long-term investors and will have gained from dividend payments over the years. It also said that it will pay for independent financial advice for any investors affected by the changes, to help them make a decision about what to do.

Q What about bank account or savings customers?

They should not be affected. The new chief, Euan Sutherland, knows it would be foolish to tamper with the bank's current ethical policy, which gives customers a say in how their money is used. It's been a cornerstone of the bank's proposition for more than 20 years, so is unlikely to change. In terms of competitive interest rates and bank charges, the Co-op should remain a credible alternative to the major high street banks. It has more than 300 branches on the high street, and 1.3 million current account customers.

Q What about mortgage borrowers?

The Co-op has pulled back from some of the riskier elements of the lending market – such as interest-only mortgages – but has remained competitive in the market, and says it will continue to do so. So borrowers shouldn't be affected.

Q Will the change mean the Co-op is no longer a mutual?

Interestingly, the Co-operative Bank has never been a mutual. It is a plc that is owned by a mutual, and that will continue. The Co-operative Group will remain the majority owner of the Co-operative Bank, which will also, in due course, have listed minority shareholders.

Q So I shouldn't move to another bank?

The ethical and co-operative stance remains the same. The competitive products and award-winning service should continue. So there's no reason to switch.

Simon Read

Timeline: Co-operative Banking Group

1810 Robert Owen founds the co-operative movement after buying a New Lanark cotton mill

1872 Loan & deposit department of Co-operative Wholesale Society formed

1876 Changes name to CWS Bank. Its initial customers are co-operative societies

1975 Joins London Clearing Banks

1999 Launches Smile, first internet bank in UK

2002 Merges with Co-operative Insurance Society to create Co-operative Financial Services

2009 Merges with Britannia building society

20 11 Rebranded Co-operative Banking Group

March 2013: Posts £673.7m loss for 2012

Yesterday: £1.5bn capital shortfall

Businesses:

Co-operative Insurance, Co-operative Investments, Co-operative Bank (including Britannia and Smile)

6.5 million customers

4 million customer accounts