How the Co-op Bank got into the mess it's in today

Bad-debt and mis-selling hits, growing losses and a junk rating from Moody's have left the one-time groundbreaker in dire straits

When a 141-year-old bank takes to the Twittersphere to try to reassure its customers, you know something's afoot. But that is just what the Co-operative Bank was forced to do in mid-April, with its press office tweeting: "In light of today's news, we would like to reassure customers and members that we haven't sought nor do we need Government support."

The Bank of England remained schtum. But then ever since the fateful Friday in September when Northern Rock customers are reckoned to have withdrawn £1bn in the first run on a British bank for 150 years, the Old Lady of Threadneedle Street has kept her counsel.

But there had been and were to be plenty of other warning signs. March saw the bank report an annual statutory loss of £661m, up from £138m, as it made huge bad-loan writedowns and took further charges for mis-selling payment protection insurance.

In mid-April, after almost a year of negotiations, Co-op Bank suddenly withdrew from a £1bn deal to buy 632 branches that Lloyds had been ordered to sell by European regulators. Project Verde had struggled on for so long that analysts questioned whether the Co-op had the capital or the management to satisfy the regulators that it could pull off the deal.

Matters were not helped by the fact that the Chancellor, George Osborne, had made it clear that he saw a Co-op Verde solution as one of the best ways to create another bank to challenge the Big Four who had been bailed out or tarnished by the financial crisis of 2008/9.

A week later, the credit ratings agency Moody's cut Co-op Bank's debt rating by an extraordinary six points, leaving it with the status of junk bonds. Co-op said it was disappointed and, while it was increasing its capital base, its funding and liquidity were "significantly above the regulatory requirements".

Analysts did not agree. Barclays suggested the Co-op could have a funding gap of £1bn on a good day, but in a "stressed" scenario it could be as much as £1.8bn. Neither the Co-op nor the Prudential Regulatory Authority (PRA) deigned to publish a number.

There were signs that some local authorities which, with the Labour Party and trade unions, bank much of their money with the Co-op, may have drawn down some funds. But there was no evidence of a run on the bank.

Meanwhile the chief executive of Co-op Bank, Barry Tootell, and the finance director, James Mack, had departed while the long-time chief executive of the entire Co-operative Group, Peter Marks, was already on his way to a long-planned retirement.

How did the Co-op Bank get here? It emerged in 1975 when it became the first UK bank for 40 years to be allowed to issue its own cheques. Over the next couple of decades, it became a groundbreaker. Not only did it play on the Co-op basics of ethical investment and mutual ownership, it was also the first bank to offer free current accounts to customers who remained in credit, and interest-bearing cheque accounts. It also launched Smile, the online bank regularly voted the best in Britain.

But in January 2009, at the height of the financial crisis, Co-op went a step too far, announcing its merger with the Leek-based, Stoke City-sponsoring Britannia Building Society. That raised a few eyebrows, given that Britannia had the previous year written off £400m of loans that mostly appeared to be not on its normal residential mortgage business but on commercial property and small business loans.

As the merger was announced, David Anderson, the then head of Co-op Financial Services who was on his way out, said: "The co-operative and mutual movements have never been more relevant. Owing to the damage done by the credit crunch, people have been crying out for a new way of doing business with a financial organisation of substance that truly has their interests at heart – this merger will create that organisation."

Neville Richardson, the chief executive of Britannia, who became chief of the Co-op Bank, said: "Britannia members have an historic opportunity to help create a new way of doing business in British financial services by voting to bring together two leading customer-owned businesses with unrivalled reputations for social responsibility, customer satisfaction, employee engagement and member democracy. They can choose to be part of something good."

Something good soon turned out to be not so good. As with another politically inspired merger – that of Lloyds with HBOS – the risk profile of Britannia turned out to be much higher than the buyer had expected. The merger of IT systems between the Co-op and Britannia took far longer and far more money that planned, and even today there is talk that the whole IT system may need to be scrapped.

Only a week ago, it emerged that Co-op Bank had drawn down £900m from the Government-backed Funding for Lending Scheme but had reduced the amount it had lent by £300m. Some commentators said that was as close to a bailout as a bank could get without it being declared as such.

Co-op Group's new chief executive, Euan Sutherland, recently appointed the former HSBC executive Niall Booker as the bank's new chief executive. That was followed by the appointment of a former Morrisons finance director to the same role at Co-op Group and Richard Pym, chairman of UK Asset Resolution, the state-owned bad banks which are the leftovers of Northern Rock and Bradford & Bingley, as chairman of Co-op Bank.

Interestingly, Mr Pym remains in post at UKAR, leading some to jest that he now chairs two bad banks.

He said: "Co-op is not a bad bank. Clearly there are some questions which we have address, and we will be doing that in full co-operation with the PRA. We are clearly focused on actions to strengthen the bank's balance sheet, and resolving the current underlying issues. This will allow us to continue to provide customers with an alternative choice to the traditional banks."

That is the key question. How can Co-op Bank restructure its balance sheet? The fact it has pulled back from much of the riskier type of lending may give it some leeway with the PRA. But it still will need more capital.

It has already sold its life assurance business to London Life for £219m and has put its general insurance business up for sale with a £240m price tag.

It could force bondholders to take a haircut and accept they may get back say 90 per cent rather than 100 per cent of their capital. But that could make raising capital in the future more difficult and more expensive.

Co-operative Group could ride to the rescue. But given its commitment to the supermarkets business and the fact that it has already all but sold the bulk of the travel business, it has only its 800-strong funeral director business obviously saleable. The pharmacies arm and the agricultural business Co-operative Farms are too closely part of the retail business to be sold.

Mr Sutherland knows that tough decisions must be made, and will have to be made soon.

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