Nearly 3 years on from the passing of the restructuring which kept Co-op Bank out of resolution the bank released its Q3 2016 Trading Update on 11 Nov. The latest on the three key challenges at the time the restructuring was passed nearly 3 years ago does not look positive.

Challenge 1: IT Transformation

From the update:

The Bank’s migration of the majority of its mainframe-based core banking systems has been rescheduled from mid-November to Q1 2017 to allow the remediation of the results of system testing. This delay will lead to additional programme costs.

The Bank continues to work with Capita to seek to agree a way forward for the transformation element of the mortgage outsourcing contract.

On 29 Sept the Telegraph reported a dispute between Co-op Bank and Capita over delivery of and payment for the transformation programme.

http://www.telegraph.co.uk/business/2016/09/29/capita-shares-plunge-20pc-on-shock-profit-warning/

So on the transformation challenge the bank will incur additional costs, a time delay (hardly likely to please the regulators) and has run into a commercial dispute with a key supplier.

Challenge 2: Capital Adequacy

From the update:

The Bank’s Common Equity Tier 1 (CET1) ratio stood at 12.6% at 30 September 2016 (13.4% at 30 June 2016).

The PRA has notified the Bank of its new Individual Capital Guidance (ICG), which became effective as of 1 November 2016. As at 30 September 2016, the Bank’s new Pillar 2A was equivalent to 14.1% of RWAs.

The Bank continues to work through a remediation plan relating to its IRB models and remains in close and continuous dialogue with the PRA in this respect.

As noted previously, under the PRA rulebook, not meeting the Combined Buffer prevents the Bank from paying variable remuneration during the period of non-compliance.

On 13 Nov the Times reported:

The Bank of England is in weekly contact with the lender because it lacks sufficient capital buffers to withstand a financial crisis.

The Co-operative Bank is to submit a bolder recovery plan to the Bank of England next month amid concerns over its financial health.

http://www.thetimes.co.uk/article/troubles-mount-for-co-op-bank-bmt8b3kkg

So the Bank is still reliant in regulatory waivers / forbearance on IRB models and has insufficient capital buffers. In view of the struggle to create a profitable core bank 3 years on from the restructuring (see 3 below), likely future run off losses on the non-core, escalating IT transformation costs and the fact that significant deleveraging and cost reduction have already been achieved it is hard to see how the Bank can generate the capital necessary to remedy this.

Challenge 3: Sustainable Business

From the update:

The Core Bank recorded an operating profit for the nine months to 30 September 2016, driven by the reduction in the FSCS levy and the gain from the sale of gilts, compared with an operating loss in the same period in 2015. The Core Bank recorded a small operating loss in Q3 2016.

Total Bank operating costs for the nine months to 30 September 2016 were 10% lower than the same period last year and 3% lower quarter on quarter.

Delivering some elements of the turnaround plan will become more challenging given that interest rates are now likely to be lower for longer and given the uncertainty surrounding the impact of the UK’s decision to leave the European Union.

So it seems despite the big reductions achieved in operating costs the Core Bank is struggling to generate a profit at the operating level. Then there are the headwinds from continued low interest rates, intense mortgage competition, conduct costs, increased IT transformation costs etc.

Based on all the above it is hard to see how the ‘recovery plan’ the Bank is preparing for the PRA will not include further pain for bondholders. The market certainly seems nervous with recent falls in both senior and subordinated bonds despite the general strength of credit markets. Co-op Bank 11% 2023 Subordinated Notes are currently trading around 80 representing a running yield of 15.8% and yield to maturity (YTM) of 13.75%. I saw the Co-op Bank 5.125% senior notes which mature on 20/9/2017 have been offered at 91.75 last week representing a YTM of 15.9%.

Obviously is is highly unusual for much shorter dated senior to be trading at a higher YTM than longer dated subordinated. In this case I put it down to legitimate fears that the combination of the need to have a credible plan to generate capital to satisfy the PRA and the issue of how to fund the £400 million at maturity of the senior next September will be the catalyst for a further restructuring of the Bank’s debt. In these circumstances the current YTM does not look attractive to me relative to the potential downside. Worth keeping an eye on though.