Co-op Bank – views from the hill
Most of the discussion on my Banking Sector and Fixed Income Discussion Forum to date has been from the point of view of investors – and understandably so. But it is always useful to try to consider the perspective of other stakeholders in this type of situation. During the 2013 restructuring the stakeholders were identified as:
- Institutional bondholders
- Retail bondholders
- Shareholders (then Co-op Group)
- The regulators (PRA and indirectly the taxpayer)
- Potential new money
So I have been taking views from the hills on the last two to paint the following picture:
The PRA / Bank of England clearly has some tough and high profile calls to make here. Sam Woods led for the PRA on the 2013 restructuring – now he is head of the PRA with Stephen Evans leading on Co-op Bank. Back in 2013, once the £1.5 billion ‘black hole’ had been identified it was made pretty clear that the PRA / BoE would formally intervene using resolution powers of a consensual market solution for raising the capital could not be found. I will always remember a very tense evening meeting I had with Euan Sutherland (then CEO of Co-op Group) and his legal guy on 30 October 2013 where I was arguing for a better deal for junior bondholders. Initially they would not budge and put it to me in no uncertain terms that I would be responsible for the bank going into resolution and needing taxpayer support if I did not agree to support what was on the table. Not a pleasant position to be put in but I held my nerve and got the deal.
There are two key conditions that must be met before a bank can be put into resolution. The first condition is that the bank must be failing, or likely to fail. This assessment is made by the prudential supervisor (the PRA in the case of Co-op Bank), having consulted the Bank of England as resolution authority. The second condition is that it must not be reasonably likely that action will be taken – outside resolution (such as liability management, disposals etc.) – that will result in the bank no longer failing or likely to fail. This assessment is made by the Bank of England as resolution authority, having consulted the PRA and HM Treasury.
So while the conditions which must be met before a bank can be put into resolution are somewhat vague and subjective the situation in 2013 was clear. The FSA/ PRA had just completed the FPC initiated evaluation of major UK banks and building societies against the requirement they should hold capital resources equivalent to at least 7% of their risk-weighted assets by the end of 2013. This identified the £1.5 billion adjustment for Co-op Bank which would have brought its CET1 ratio down to about 1% of its Risk Weighted Assets. This would have been well below all thresholds, including the Pillar 1 absolute minimum for the Bank to retain its authorisations, so resolution was the only option if the consensual restructuring to recapitalise the Bank had failed.
However, the situation this time around is somewhat different. The Bank has announced its current CET1 ratio is currently above 10% but expected to fall below and, crucially, forecast to stay above the minimum Pillar 1 threshold. The current minimum Pillar 1 requirement that all banks must meet at all times is 6% Tier 1 capital of which 4.5% must be CET1. Co-op Bank does not have any AT1 capital so read that as 6% CET1. The problem Co-op Bank faces is that its Individual Capital Guidance (ICG) set by the PRA is currently a whopping 14.1% which it is already well below with the deficit forecast to worsen. For comparison the PRA has set Nationwide Building Society’s ICG at just 6.2%. Co-op Bank’s ICG reflects its exposure to future losses, its use of the IRB method for valuing its Risk Weighted Assets (RWAs), systems issues, pension deficit risk etc. However, these problems could largely be resolved under new ownership if a large trade buyer were to be found. Also Co-op Bank could potentially generate about £450 million of new CET1 (about 6% of RWAs) by a liability management exercise (LME) to convert its Tier 2 bonds into equity. So providing this course of action is available I do not see the necessary conditions being met for the PRA/BoE to put Co-op Bank into resolution unless the management were to throw in the towel. So, without a buyer coming forward, I think the PRA will allow Co-op Bank to continue with a LME for its subordinated bonds with a plan to find a buyer for all or parts of the Bank in the future.
Potential New Money
I do not think it will make sense for private equity or hedge funds to buy Co-op Bank because they would not be in a position to solve the Bank’s major problems. However buying the bank at a low equity price, conditional on some form of coercive LME, could be attractive for a large trade buyer. Another bank could be able to solve the Bank’s major problems (capital requirements, costs, asset yields, systems) fairly quickly. As illustrated by the difference referred to above between the PRA’s ICGs for Co-op Bank and Nationwide Building Society it seems a decent bet that the PRA would allow another institution to run the Bank at a lower CET1 than is currently required. The costs would be a natural synergy and almost any other institution likely has better systems than the bank has currently.
To run an example lets assume another bank could buy all the equity for £1. The question then would be how much capital would they need to inject? Assume Co-op Bank’s CET1 ratio is currently 8%, how much would a larger bank be required to recapitalise it to? 15% seems on the high side if it was a small portion of a larger bank but lets go with it. So £500 million of new capital (plus £1 for the shares) to get to 15% CET1 also gets a buyer 100% of £1.1 billion of CET1 (tangible book would be more like £1.4 billion). So depending a buyer’s multiple of choice (Price:CET1 or Price:TBV) they would have bought at 0.45x or 0.35x book multiple. That seems to give a potential buyer a fair amount of downside protection. The question then becomes could the buyer make Co-op Bank profitable? A bigger better run bank would have the best chance but that is open to debate. There would certainly be headwinds such as the potential loss of the Co-op brand and associated loss of customers.
For a buyer there are other potential avenues of value. Firstly, in the context of being part of a larger bank, Co-op Bank would possibly be overcapitalised at 15% and there might be an opportunity in the not too distant future to distribute back some of that ‘excess’ capital. For example if a buyer could get some tacit agreement pre-purchase with the PRA that pending restoring the Bank to profitability it could be run with a 12% CET1 ratio, then that immediately deleverages the purchase for a buyer. The net investment becomes only £300 million and the Return on Investment might start to look extremely attractive. Secondly, Co-op Bank has about £350 million of Deferred Tax Assets (DTAs) off balance sheet which cannot be recognised from an accounting perspective due to lack of foreseeable taxable profits. The DTAs alone could be more than a buyers’s in this scenario and therefore a buyer would have essentially got the bank for free at that stage.
So I am painting a pretty good scenario here but it is an interesting way of looking at it and food for thought and further debate. I have added this blog post to the Discussion Forum as well so please pop in to share your thoughts.