RegulationMar 27 2019

Regulator failed to spot warning signs in lender's trouble

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Regulator failed to spot warning signs in lender's trouble

The investigation into the near collapse of the Co-op Bank has accused the regulator of failing to address a number of warnings about the lender's financial shortcomings.

The Prudential Regulation Authority today published its independent review into the events leading up to the near failure of The Co-operative Bank in 2013 and the role played by the then regulator, the Financial Services Authority.

The review examined the merger of the Co-op Bank with Britannia Building Society in August 2009 and Co-op’s failure to buy 632 branches from Lloyds Banking Group in 2013 due to capital shortfalls. In particular, it reviewed the period between May 2008 to November 22, 2013.

It concluded the FSA should have tackled the bank's loan impairment sooner than it did.

Mark Zelmer, a former senior official at the Bank of Canada who conducted the review, said the Co-op Bank's loan performance indicators were "fairly crude" and mainly focused on the current performance of loans rather than future potential issues, such as refinancing risk.

He said: "Unfortunately, refinancing risk was more pronounced for the Co-op Bank than its peers and this was not addressed in depth until the first quarter of 2012.

"The broad remit of the FSA supervision team during the review period may have diverted their focus from the most acute issues regarding the adequacy of the bank’s loan loss provisions and the fragility of its capital position."

He added: "Despite being cognisant of the weak performance of the corporate loan book, I consider that the FSA’s supervisors did not pay enough attention to the refinancing risk that existed in that book and, in line with standards at the time, the adequacy of loan loss provisions in the period following the merger.

"I firmly believe that there should have been a greater and earlier focus by the FSA on reviewing the quality of the loan book and its valuation and ensuring adequate capital was in place to cover potential losses."

The review found that nearly 40 per cent of Britannia's loan book was "lower quality" intermediary mortgage business but the FSA did not consider it to be a concern which warranted reviewing.

But Mr Zelmer concluded it would have been unreasonable to say the FSA should have developed its stress-testing approach sooner.

He said: "A significant level of impairments was identified in the stress tests undertaken in 2009 as part of the FSA’s assessment of the merger.

"While the exercises were less sophisticated than those in use today, they nevertheless produced results that were broadly consistent with those of later exercises.

"Consequently, the FSA approved the merger in 2009 knowing that there would be vulnerabilities in the merged bank's balance sheet and that there was a risk that the bank would need more capital in coming years."

He said Co-op Bank also suffered other losses due to conduct issues and the write down of IT expenditure totalling more than £600m in the period reviewed that were not fully identified by the stress tests.

"While these types of risk are better known today and receive greater attention in current stress test exercises, the inclusion of these risks in those exercises in the UK and elsewhere remains a work in progress," he said.

Mr Zelmer added the PRA and Bank of England should continue to evolve their stress test exercises to encompass a broad range of risks to which banks are exposed.

The review also questioned whether reforms made by the regulators to manage bank crises will be sufficient in situations where the financial system encounters a major systemic failure.

He said: "Indeed, I think the likelihood of such systemic situations involving smaller institutions may in fact be greater in the future.

"Past experience has shown that runs on deposits can happen fast in a digital world, and this risk may continue to grow with the introduction of ‘Open Banking’.

"At the first hint of any problems those third party providers may be highly motivated to move money away, or encourage their deposit clients to do so, from a potentially troubled institution, no matter how strong the deposit insurance scheme or the resolution toolkit, to protect their own reputations."

Charles Randell, chairman of the Financial Conduct Authority, which replaced the FSA in April 2013, said in response to the report the approach to regulation had changed significantly since the period covered by this review, as the PRA and FCA were established as separate regulators.

He said: "Mark Zelmer’s report relates to the prudential supervision of banks now performed by the PRA. The FCA will reflect on the findings and recommendations where relevant."

In a joint statement responding to the review, the PRA and BoE stated they agreed with the recommendations made by Mr Zelmer, but added: "While the PRA agrees it is important to balance and consider how it advances its objectives, it is important to recognise that the PRA’s objectives are set by Parliament.

"The BoE has made significant progress in improving the resolvability of firms as part of the broader ‘too big to fail’ agenda.

"The Bank acknowledges that more progress needs to be made where failures occur in systemic situations.

"While the Bank is solely responsible as resolution authority for exercising the statutory resolution tools, the PRA will continue to apply its rule-making powers where appropriate to improve the resolvability of firms."