Will smaller lenders sign a mutual agreement?

Medium-sized building societies may soon unite to see off takeover threats from their larger rivals. Sean Farrell reports

The market for financial services may be global but, when it comes to mergers and acquisitions, action is closer to home in the traditionally sleepy world of building societies. Norwich & Peterborough (N&P) is the latest lender to consider giving up independence by entering merger talks with Yorkshire, the country's second-biggest society. If the deal is approved, it will be the 12th merger of mutuals since the start of 2008 – a period that has seen names such as the Chelsea, Derbyshire and Kent Reliance swallowed up.

The reason for the merger wave is, of course, the financial crisis. The slump in mortgage lending, ultra-low interest rates and increasing regulation have hit societies' profitability. However, the crisis also exposed racy behaviour at some societies whose customers thought they were depositing their savings with safe, often local institutions.

Dunfermline BS was rescued by Nationwide after diversifying into commercial lending – an altogether riskier business than residential loans. Losses from investing in Iceland caught out the Barnsley and Chelsea building societies, which racked up losses on buy-to-let lending. Meanwhile, N&P was forced to seek a merger after it was left on the hook for selling investments in the failed company Keydata. Steve Williams, the head of the building societies group at Deloitte, says: "For some societies, reducing profitability and the low interest rate environment means they are not regenerating their capital. That restricts what they can do, and if a problem comes along they cannot raise capital in the markets so the only option is to merge."

In each case, the societies moved away from home loans and retail deposits in an attempt to be more profitable, either by seeking bigger margins on lending and treasury investments or adding new services. The most acquisitive have been the Yorkshire BS and the country's biggest mutual, Nationwide. Including N&P, the pair have mopped up seven rivals in just over three years.

Most of the struggling lenders were from the large swath of midsize societies that lack both economies of scale to compete nationally and the niche appeal of very small outfits. Chief among these tiny local players is the Staffordshire Railways building society, which has shunned all forms of excitement for more than 100 years and had £23,000 of arrears on £140m of loans last year.

Iain Cornish, the chief executive of Yorkshire, says the sector has been forced to pay the price for reckless behaviour of former mutuals that became banks in the 1990s.

"If you look back 10 or 15 years, that is when the conversions of Halifax and Northern Rock took place. They competed on a completely unsustainable basis and drove all the profit out of traditional building society activities and that is why a number of societies chose to diversify.

"By and large, for those that overreached themselves in commercial or buy-to-let lending those things aren't necessarily wrong but they didn't do them to a high standard and did too much for their size."

All the demutualised societies – Abbey National, Halifax, Northern Rock, Alliance & Leicester and Bradford & Bingley – had to be rescued. Mr Cornish believes the societies are about three-quarters of the way through an "orderly restructuring" that, unlike the bailed-out banks, has not relied on taxpayer support. That promises a few more deals but the societies' leaders argue that the wave of mergers will not lead to a shrinking of the mutual sector.

The high-water mark for building societies was at the end of the 19th century when there were about 2,500 lenders. They have been combining since, and there were 14 mergers in 1987 alone. But to prosper the remaining societies will have to toughen up, says Adrian Coles, director general of the Building Societies Association. He points to the rising costs of regulation through the Financial Services Compensation Scheme, as well as the cost of dealing with the multiple new agencies that will replace the Financial Services Authority. "We cannot find any indicator of customer service on which the banks beat the mutuals," he says. "But there will have to be control of costs, control of risk, sensible pricing policies and good profitability. Mutuals have seemed to be about being nice and being like a charity but now it is about being profitable and being there for the long term."

The sector is left polarised between the top lenders and the small local players. Midsize lenders are looking at options such as sharing administrative support and some observers even think that a federation would be the answer. Mr Williams at Deloitte says: "To succeed, other societies will have to be fleet-footed and enter niche markets quickly, but their dilemma is that the regulatory framework is quite tough and limits their ability to do that.

"There will be a trickle of further mergers but it will not be wholesale. You have got a sector that is on the road to recovery but among the 48 societies there is still a bit of colour, and certain societies will have some challenges ahead."