The economic outlook was so gloomy that the deal no longer seemed worthwhile, a bank spokesman said. This seemed odd even at the time. No firm undertakes a takeover that would greatly affect the size and structure of its business for years to come on the basis of the next couple of years’ prospects. Now it has become clear that other factors were at play. Not only has recent data shown that the economic outlook is brighter than the statement implied – which, to be fair, the Co-op could not have foreseen – but, as Moody’s has made clear, there is quite a lot that needs attention at the Co-op itself before it starts taking over new businesses.
Explanation
The lesson is: statements made immediately after a takeover is called off do not always give a complete explanation of what went wrong.
But, there are two much more important lessons. Both have implications for current and future discussions of the shape and structure of the banking industry, and for its regulation. These relate to how the risks of certain types of lending should be viewed, and to the appropriate corporate form for banks.
Conventionally, lending on property (especially residential property) has been viewed as safe. This has led to its being given a very low risk weighting by the Basel Committee. In the US shortly before the banking crisis, Ben Bernanke, chairman of the US Federal Reserve, stated that he was unconcerned about the mortgage market because there had never been a nationwide house price crash in the US. And, of course in Britain, building societies are conventionally viewed as stable, safe places for small savers.
The first lesson to be learned – although it could have been learned before, from the failure of Northern Rock, for example – is that property lending, even on residential mortgages, is not absolutely safe. How safe it is depends on many things, but most basic is the standard of the lending. What proportion of the house price has been lent? Who did the valuation, and how conservatively? What multiple of income was advanced? Was the declared income confirmed by an independent party?
All these have been neglected in recent years, but despite that it has been generally believed that a mortgage is just a mortgage – all are the same, and all are secure. I doubt if Ben Bernanke made that elementary error, but he made another more sophisticated one, and one that matters in the UK. He neglected to note the importance of a major change in the US banking system that had made it more like the UK one.
This is nothing to do with the formal ending of the separation between commercial and investment banking. Rather it is that banks in the US were no longer confined to individual states. There had been no nationwide house price crash in the US because however badly lending standards slipped in one state, however badly a state did economically, the problems were confined to that state because the only significant connection between the banks of different states was through the Federal Reserve. That changed, and the problems could spread nationwide, just as in the UK. One should always pay attention to major changes in the institutional environment of financial institutions, which is just what Bernanke failed to do.
And what about commercial property? No one should have believed it is always safe. All the questions that apply to residential mortgage lending apply to commercial, and it is much more exposed to the business cycle and much more concentrated than residential lending. Anyone who has forgotten this has forgotten the recent problems of HBoS, and also Britain’s secondary banking crisis.
Even more important than the riskiness of property lending is the lesson about banking structure that the merger’s problems demonstrate.
Mutuals are being touted as friendly organisations that always treat their customers well, in contrast to other kinds of firm. Will that inevitably be the case? In the past there have been numerous instances of executives not controlled by the rightful owners of stock-type firms – the shareholders. Why should the management of mutuals be any different? There are good, honest and competent people in all sorts of firms, regardless of the form those firms may take. And governance – how well the executives are controlled – matters.
The Moody’s downgrade highlighted an even more vexatious issue. Even the most skilled and cautious of bankers may be affected by the pure misfortune of an unforeseeable event. Should a bank be hit by one of these, it may need to raise capital. Who can it raise it from? A normal firm in the first instance can and should go to its owners, the shareholders. Who can a mutual go to? I cannot inject capital into the Co-op simply because I occasionally buy groceries there. In other words, mutuals do not have a natural source of contingency capital, and banks need to have that. The form of a mutual is not really suited to the finance sector.
Survival
Some may ask: how can that be said when many building societies have survived in that form for so long, and provided a good service? The answer is clear. They did it by knowing the area in which they operated, knowing their customers, and exercising great caution in lending. They are not well suited, therefore, to providing the wide range of services that many customers, and certainly commercial ones, require of a bank.
Ultimately, when thinking about the future, we must remember that whatever their attraction, mutuals can – and more importantly should – only play a modest part in the structure of banking in the UK.
Geoffrey Wood is professor emeritus of economics of Cass Business School
Key points
- Statements made immediately after a takeover is called off do not always give a complete explanation of what went wrong.
- Conventionally, lending on property (especially residential property) has been viewed as safe.
- Mutuals do not have a natural source of contingency capital, and banks need to have that.
