Is it merge or die for building societies?

As more mutuals have to join forces to survive, Julian Knight investigates what the future holds for the banks' competitors

It's the banks that screwed up but the building societies are now suffering. Britain's third and fifth biggest mutuals, the Yorkshire and the Chelsea, announced plans last week to merge to form the third "super mutual" along with the Nationwide and the Co-op-Britannia. At the same time, the middle-sized Norwich & Peterborough closed 10 branches blaming the move on "unfair competition" from the semi-nationalised banks.

These are difficult times for building societies, probably even more so than the wave of demutualisations that saw Halifax, Alliance & Leicester and Bradford & Bingley all ditch their mutual status in the early 1990s. Currently, there are 52 building societies; by the time this round of mergers has gone through, there could be far fewer.

"We and other societies are caught in a huge margin squeeze," said Matthew Bullock, the chief executive of the Norwich & Peterborough. "The money we are getting from our investments is lower than we have to pay out to savers. The Financial Services Authority requires that we hold a lot more capital in government bonds which are paying around 0.5 per cent. At the same time, the banks have suddenly become keen to attract customer deposits – as this is an alternative to the money markets – and are paying over the odds. I have one branch offering a bond at 3.25 per cent, while next door C&G (part of the largely government-owned Lloyds Banking Group) is paying 3.75 per cent.

"It's difficult to make money when you are seeing the money you receive for your investments reduce, while attracting new capital is becoming more expensive because of the banks, which are sitting on a £150bn cash pile from the Government bailout."

As for turning to the money markets, the downgrading of some societies' credit rating makes this an expensive option, despite the interest rate at which financial institutions lend to each other – called Libor – falling markedly in recent months.

Andy Caton, the corporate development director at the Yorkshire and a leading figure in the society's merger with the Chelsea, said: "There is some crowding out, due to the banks targeting savers as well as the government-run National Savings and Investments. What do I see in the future? The smaller societies provide bespoke services to local communities but national operators will have to compete with the banks and that means strong capitalisation." In other words, more mergers are on the cards.

But what does all this mean for customers? Does it matter that we are seeing so many building society names disappear? After all, customers of the Cheshire and Derbyshire societies were probably relieved at the Nationwide rescue in 2008 as the alternative was possible administration.

"If we see the number of societies fall to, say, 10, it won't be the end of the world, provided that they still remain distinctive in their business practices and don't try to ape the banks in their lending," said Andrew Hagger from comparison site Moneynet. And societies do have some big lessons to learn from the boom before the credit crunch with the Cheshire, Derbyshire, Chelsea and Dunfermline societies getting involved in sectors such as sub-prime lending, buy to let and commercial property.

And although the banks have muscled in on the savings market, there are still some good deals from societies. "If you have bad lending, bad investments or a bad fraud the market is unforgiving. What we have seen to date has been largely due to bad lending and subsequent arranged marriages between societies. In future, though, mergers will be more about cost savings and combating the squeeze on margins," Mr Bullock said.

But despite the staking out of territory in the savings market by the banks, there are still some stand-out accounts offered by the societies. Even in cash individual savings accounts, where the banks have made the biggest splash in recent months, five of the top 10 paying accounts still come from building societies, although two of these three high-paying accounts, from the Chesham and Newcastle, include an introductory bonus rate.

As for home loans, David Hollingworth from mortgage broker London & Country says that the banks have "stolen a march on the building societies with HSBC and even the nationalised Northern Rock taking market share". In the darkest days of the credit crunch, many building societies seemed to withdraw almost completely from the home loan market, setting mortgage rates at such a high level that, in effect, few borrowers would come to them. Alternatively, good rates would be available only with substantial strings attached such as having a 25 or even a 40 per cent deposit.

"It's crucial to keep as many societies as possible in the mortgage game. Despite the problems of some, as a sector they tend to be more inventive than the banks," said Mr Hollingworth. "The Coventry, for instance, has a 125 per cent mortgage designed to help people in negative equity. My fear is that consolidation among building societies will ultimately mean less mortgage choice and worse rates for consumers."

But Mr Caton reckons that a more streamlined building-society sector would still be a tough competitor to the banks. "Banks will also consolidate and will look to maximise profits. This gives mutuals an opportunity as we don't need to satisfy shareholders. I think now there is a clearer perception in the minds of consumers between the banking and building society models," Mr Caton said.