The curse of conversion

And then there were none. The abrupt collapse yesterday of Bradford & Bingley, a proud institution with more than 155 years of history, means that not a single one of the six building societies that have converted to banking status over the past 20 years remains independent.

Abbey National, the first society to embrace demutualisation in 1989? Sold four years ago to Santander. Alliance & Leicester is in the process of selling to the same Spanish bank, while Woolwich was snapped up by Barclays in 2000. Northern Rock and Bradford & Bingley? Well, we all own them now. And even Halifax has succumbed to a rescue bid from Lloyds TSB.

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It wasn't meant to be this way. In 1997, when four building societies converted to banking status via stock market flotations in the space of six months, a small band of the sector's loyalists decried demutualisation as a dirty word. They were branded luddites by the boards of Halifax and the rest, who were desperate to pursue the relative freedoms on offer if they became banks – particularly the freedom to access capital markets for expansion.

Nor were many building society customers too exercised by the demutualisations, because the deals were sweetened with free windfall shares worth hundreds or even thousands of pounds. In the summer of 1997, many society branches faced long queues of potential customers anxious to join up before demutualisation was announced in order to grab the hand-outs. The carpetbaggers made it difficult for staff to go about their normal business and ensured that members backed conversion en masse when it was put to a vote.

Those who sold their windfall shares straight away made a tidy profit, but many millions of former building society shareholders have not been so lucky. About 100,000 small Northern Rock shareholders still do not know how much – if any – compensation they will get following the bank's collapse last year. B&B's 850,000 retail investors are unlikely to get anything. And investors in all the other ex-societies have watched their shares halve and then halve again.

For the 2.1 million small shareholders in HBOS, for example, whose investments have lost more than 80 per cent of their value, the rigid rules that until 1997 applied to Halifax Building Society must suddenly look rather attractive.

Since the very first Building Societies Act was passed into law in 1836, there have been no fewer than nine further major pieces of legislation defining what society directors may, and more often may not, do. Most of that law restricts the industry to the basic activity for the purpose of which the first society was formed in 1775– enabling members to pool savings so as to provide funds for house purchases.

Building societies, for example, are subject to strict limits on borrowing from wholesale money markets to fund mortgage issues. Just as important, access to capital markets is strictly limited, which means the sector has not been able to emulate the balance sheet expansion of its banking rivals.

Some building society legislation has been liberalised. The 1986 Building Societies Act, for example, was an initiative of a Margaret Thatcher government that believed absolutely in the free market. As well as giving societies the right to compete more aggressively against banks, it also made demutualisation a much simpler process, paving the way for the windfalls of the Nineties.

Few that took up the opportunity have prospered. The strategy of Abbey, for example, was to diversify into every conceivable area of financial services and it came a cropper well before the credit crisis. Similarly, B&B's business model – specialisation in risky areas of the market – also looked ropey before the crunch came along. The purchase of the mortgage broker John Charcol, subsequently sold on at a knock-down price, was an early example of the poor management of the plc operation.

Rod Kent, the former B&B chief executive, believes its building society origins saddled it with outdated processes – and that this, rather than conversion itself, underlie its recent woes. Vince Cable, the Liberal Democrats' Treasury spokesman, is not convinced. "The collapse of Northern Rock and Bradford & Bingley are prime examples of the disastrous policy of turning building societies into banks, which was pursued by the last Tory government," he says.

What the former mutuals had not expected, of course, was the biggest financial crisis since the Great Depression. And when it arrived, they simply did not have the strength to withstand its severity. If HBOS could not survive, then B&B was never going to be able to either.

Not that building societies are unaffected by the credit crisis – and some are more risk-averse than others. Britannia, the second-largest society, last month reported a 40 per cent fall in its pre-tax profits for the first half of the year after revealing impairment charges of more than £40m. About a quarter of Britannia's mortgage lending is in areas such as buy-to-let, credit-impaired and self-certification, which are widely perceived as more risky.

Neville Richardson, Britannia's chief executive, admits the speed with which the credit crisis escalated took them by surprise. "We're not immune to the market downturn and our business model anticipated losses arising from some of our lending," he says. "The slowdown in the wider economy means we believe those losses may come about more quickly than expected, but we're taking the necessary action to contain them."

At least Britannia has not been holed beneath the water line by such problems, like its smaller colleagues Derbyshire and Cheshire. The two societies are in the process of being taken over by Nationwide in a deal brokered by the Financial Services Authority (FSA) to protect savers and borrowers. Members of both societies are being given no say on the takeover and will receive no windfalls, with the FSA pushing the mergers through before the scale of Derbyshire and Cheshire's problems emerged.

Even leaving aside the credit crunch, the building society sector is likely to consolidate further. As recently as 15 years ago, there were more than 120 independent societies. Today, as the industry faces higher costs for ever-more complicated compliance procedures and IT systems, the figure is below 60. Most of the reduction has come through mergers rather than demutualisation.

Despite such problems, Adrian Coles, director-general of the Building Societies Association, says the credit crunch has been a watershed moment for the mutual sector. "No doubt we will see more building society mergers in the future, but this will not mean the mutual model is destroyed," he says. "Many commentators seem to be making the point that the demutualised model has been."