Open Letter to PRA on behalf of Co-op retail investors

Andrew Bailey Esq.

Chief Executive Officer

Prudential Regulation Authority

20 Moorgate

London, EC2R 6DA

9 July 2013

Dear Mr Bailey

I am writing on behalf of over 15,000 pensioners and retail investors who have entrusted their savings in Co-operative Bank PLC (‘the Bank’) preference shares and permanent subordinated bonds  (‘PSBs’) and who rely on the interest and dividends for income. Over 1,300 have contacted me in great distress since the Bank’s recent announcement concerning the Prudential Regulation Authority’s (‘PRA’) view of its capital requirement and plan for addressing it. As a result, I am writing to request that the PRA review the requirement and timetable that it has imposed on the Bank and the plan which it has agreed with the Bank in light of the following facts:

1.         The PRA’s predecessor regulator, the Financial Services Authority, approved the Bank’s acquisition Britannia Building Society in 2009 (Note 1) and should have been aware of the nature of  Britannia's lending activities (including securitization of sub prime mortgages), Commercial Real Estate loan book and associated risks.

2.         The banking regulators (FSA now PRA) have admitted to the TSC (Note 2) that they were aware that the Bank needed to raise capital and had a range of other issues to address including governance and management as far back as 2011 but made no public disclosure and seemingly did nothing to require the Bank to take action. . Furthermore, in your evidence to the TSC you said that you had conducted a stress test of the Bank in 2012 which revealed deficiencies that the Bank needed to address. This result was also not disclosed.

3.         The Bank and Co-op Group (100% shareholder responsible for governance, accounts, management, major decisions at the Bank) must have been aware of the need to raise capital and loan book issues but made no public disclosure and seemingly did nothing to take action.

4.         Meanwhile the UK Government was publicly endorsing the Bank as a virtuous role model for banks, not involved in 'casino banking' and, as a 39% shareholder in Lloyds Banking Group, supported the award of preferred bidder status to the Bank for Lloyd’s major disposal programme, Project Verde.

5.         The Bank's latest accounts released at the end of March 2013 stated:

Capital resources (audited)

Adequate capitalisation can be maintained at all times even under the most severe stress scenarios, including the revised FSA ‘anchor’ stress scenario. A capital buffer above Individual Capital Guidance (ICG) is being maintained, to provide the ability to absorb capital shocks and ensure sufficient surplus capital is available at all times to cover the Bank’s regulatory minimum requirements.

The regulator must have provided comfort to the Bank's auditors in respect of this statement.

6.         The above failings created a false market in Bank’s London Stock Exchange listed preference shares and PSBs, in direct conflict with the role of the regulators to protect investors’ interests.

7.         Now that the problems have come to light and despite its previous inaction the PRA is inflicting an arbitrary and putative 9% core capital ratio and implies that the Bank is a Systemically Important Financial Institution – which it clearly is not. This is double the Bank of England’s minimum capital requirement of 4.5% (Note 3) and significantly above the endpoint Basle 3 target for 2015 of 7%. This action on the part of the PRA is clearly disproportionate and in direct conflict with its recent (April 2013) stated approach to banking supervision:

 

The PRA is committed to applying the principle of proportionality in its supervision of firms. In this context, proportionality is judged in terms of the threats that firms can pose to the PRA’s statutory objectives. An important first step in the direction of applying the principle of proportionality is described in the recent publication on barriers to entry for new firms.

I believe that this step also represents a commitment to apply the principle set out in the new legislation that the PRA should have regard to minimising adverse effects on competition in the industries it regulates when pursuing its statutory objectives.

http://www.bankofengland.co.uk/publications/Documents/praapproach/bankingappr1304.pdf

8.         At the same time the PRA has endorsed the Bank’s capital raising plan (Note 4) which seeks to inflict the largest relative burden on the Bank's 15,000+ retail bondholders who trusted the regulators, politicians, bank and its accounts and are the one blameless group in this national disgrace. 

9.         The punitive capital requirement set by the PRA is based on severe stress provisions for losses which, by definition, will likely not crystallise in the future. Bondholders are being expected to front load the balance sheet now to cover these unlikely maximum future writedowns while the Co-op Group, despite having presided over the collapse of its banking arm, keeps the lion's share of the Bank and will benefit most from the likely future writebacks. This upending of the established hierarchy of capital hierarchy with the blessing of the PRA would set a dangerous precedent and is in direct conflict with the Directive of the European Parliament and of the Council, for establishing a framework for the recovery and resolution of credit institutions. (Note 5)

10.       Not only are the PRA's actions causing great distress they also threaten to cause an avoidable standoff which could result in unnecessary nationalisation of the Bank and massive damage to the Co-operative Group and mutual sector.

As a direct result of the PRA's recent punitive and disproportionate actions we have moved away from a situation of the Co-op Group being prepared to do more to support its Bank, bondholders being willing and expecting to contribute on a voluntary basis and the requirement of approximately £800 million suggested by the audited accounts would have been filled. But the PRA's position and inflexibility (it is treating the Bank as a Systemically Important Financial Institution) has caused everyone to dig their heels in, threatens to cause a standoff and risks an outcome nobody wants. It is therefore the PRA which has to move and act as follows without further delay in order to avert a crisis:

i.          Review the £1.5 billion capital requirement and timetable that it has imposed on the Bank and the capital raising plan which it has agreed with the Bank.

ii.         Publish the basis on which the £1.5 billion capital shortfall has been determined.

iii.        Clarify that the absolute legal minimum CT1 capital requirement for the Bank is 4.5% at the moment and Individual Capital Guidance (ICG) of no more than 7% is appropriate rather than the arbitrarily high 9% which has been imposed.

iv.        Be honest with the market on what commitments the PRA has obtained form the Co-op Group in terms of future support for the bank. At a minimum please clarify that you have obtained an ironclad guarantee that the proceeds from the insurance businesses will be injected into the bank in all circumstances. 

Yours sincerely

 

Mark Taber

Email: mark@fixedincomeinvestments.org.uk

Tel: 01761 220027

Cc:       George Osborne – Chancellor of the Exchequer

            Mark Carney – Governor of the Bank of England

            Lord Deighton (Commercial Secretary to the Treasury)

            Andrew Tyrie, Jesse Norman (Treasury Select Committee)

            Lord Myners


 

Note 1:  Question asked by Lord Rooker in the House of Lords on 1 July 2013:

To ask Her Majesty’s Government which financial regulator approved the purchase by the Co-operative Bank of the Britannia Building Society.[HL1022]

The Commercial Secretary to the Treasury (Lord Deighton): The purchase of the Britannia Building Society by the Co-operative Bank was approved by the Financial Services Authority.

http://www.publications.parliament.uk/pa/ld201314/ldhansrd/text/130701w0001.htm

 

Note 2:  Andrew Bailey of the PRA in evidence to the TSC on 2 July 2013:

Towards the end of 2011 we made it clear to them that—and I will use these words carefully—it was not clear to us that the Co-op Banking Group had the ability to transform itself successfully and sustainably into an organisation on the scale that would result from acquiring the Verde assets. Then we set out five things, the five areas that they would have to deal with: capital, liquidity-risk management, integration, governance and management. That is obviously a pretty full set, as you might say.

http://www.parliament.uk/documents/commons-committees/treasury/TC%2002%2007%2013%20(2).pdf

 

Note 3:  From the Bank of England’s March 2013 - A review of requirements for firms entering into or expanding in the banking sector:

The PRA is also proposing additional measures when the Capital Requirements Directive IV (CRD IV) comes into force: following full implementation of Basel III, new entrant banks will initially only need to meet a common equity tier one (CET1) capital of 4.5% of risk-weighted assets8 versus the 9.5% rates applicable to major existing banks.9 New entrants will be given longer to build up the additional 2.5% of capital required under Basel III (Chapter 6).

tp://www.bankofengland.co.uk/publications/Documents/joint/barriers.pdf

Recently published EU legislation on Basel 3 requires 4% CET1 from 1 January 2014:

Article 465

Own funds requirements

1. By way of derogation from points (a) and (b) of Article 92(1) the following own funds requirements shall apply during the period from 1 January 2014 to 31 December 2014:

(a) a Common Equity Tier 1 capital ratio of a level that falls within a range of 4 % to 4,5 %

(b) a Tier 1 capital ratio of a level that falls within a range of 5,5 % to 6 %.

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:176:FULL:EN:PDF

 

Note 4: The PRA’s attempt to distance itself from the Bank’s plan by stating how the capital is raised is a matter for the Bank does not stand up to scrutiny. For example:

i.          In an email of 17 June 2013 the Bank’s Head of PR confirmed that the PRA is supportive of the plan as follows:

Mark,

As I said to you on Friday, I did not speak to the Telegraph.

As for ‘external support’, that was the phrase used by Moody’s on 9 May to (wrongly) suggest  we might need a taxpayer-funded Government bail-out.

As you can see from the plan announced today, which the PRA are supportive of, we don’t.

 

Patrick

ii.         The Bank’s 17 June 2013 announcement of its capital raising plan stated:

The plan has been discussed in full with the regulator.

And

Until further notice, the Bank will only pay discretionary coupons on any Target Securities left outstanding if permitted to do so by the PRA, and in particular will not pay the coupon on the 13% Perpetual Subordinated Bonds (ISIN GB00B3VH4201) that would have been due on 31st July 2013 without such permission.

http://www.londonstockexchange.com/exchange/news/market-news/market-news-detail.html?announcementId=11615411

There is nothing in the terms of the preference shares or PSBs which requires the PRA approve payment of interest so the PRA must be stipulating elements of the Bank’s plan. Furthermore deferral of interest does not generate any capital and many actually erode it as the bonds are cumulative and the preference shares have a step up payment in kind provision which would reduce the Bank's capital.

iii.        The terms of the Bank’s PSBs require FSA (superseded by PRA and FCA) consent for it to repurchase the bonds. The relevant section of the Trust Deed states:

5.3      Purchases

The Issuer or any of its subsidiaries (as defined in section 1159 of the Companies Act 2006), subject to the Issuer having given at least one month's prior written notice to, and received no objection from, (or in the case of any purchase prior to the fifth anniversary of 1 August 1992 (being the issue date of the 1992 PIBS), receiving a waiver, so long as there is a requirement for such a waiver, from) the FSA (or such shorter period of notice as the FSA may accept and so long as there is a requirement to give such notice), may at any time purchase Bonds in any manner and at any price. If purchases are made by tender, tenders must be available to all Bondholders alike. Such Bonds may be held, reissued, resold or, at the option of the Issuer, surrendered for cancellation.

It is, therefore, entirely within the control of the PRA to dictate the terms on which the Bank's proposed capital restructuring can be made and to ensure that the hierarchy of creditors is preserved, since it follows that the bank is unable to offer to purchase the bonds in exchange for any other securities without the express permission of the PRA. 

 

Note 5:  From http://ec.europa.eu/internal_market/bank/docs/crisis-management/2012_eu_framework/COM_2012_280_en.pdf

(49) In general, resolution authorities should apply the bail-in tool in a way that respects the pari passu treatment of creditors and the statutory ranking of claims under the applicable insolvency law. Losses should first be absorbed by regulatory capital instruments and should be allocated to shareholders either through the cancellation of shares or through severe dilution. Where those instruments are not sufficient, subordinated debt should be converted or written down. Finally, senior liabilities should be converted or written down if the subordinate classes have been converted or written down entirely

Recently published EU legislation on Basel 3 requires 4% CET1 from 1 January 2014:

Article 465

Own funds requirements

1. By way of derogation from points (a) and (b) of Article 92(1) the following own funds requirements shall apply during the period from 1 January 2014 to 31 December 2014:

(a) a Common Equity Tier 1 capital ratio of a level that falls within a range of 4 % to 4,5 %

(b) a Tier 1 capital ratio of a level that falls within a range of 5,5 % to 6 %.

http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:176:FULL:EN:PDF

The PRA is enforcing a higher CET1 requirement of 7%:

 “The PRA should assess current capital adequacy using the Basel III definition of equity capital but after: (i) making deductions from currently-stated capital to reflect an assessment of expected future losses and a realistic assessment of future costs of conduct redress; and (ii) adjusting for a more prudent calculation of risk weights.”

The PRA should take steps to ensure that, by the end of 2013, major UK banks and building societies hold capital resources equivalent to at least 7% of their risk weighted assets, as assessed on the basis described in Recommendation 11

http://www.bankofengland.co.uk/publications/Pages/news/2013/081.aspx

For some unexplained reason the above calculation is forcing banks to raise enough capital in 6 months to cover the next three years losses under a severe stress scenario, which seems a harsh measure in light of improving economic conditions:

A “base testing” approach was adopted, assessing expected future losses over a three-year period using data provided by firms - this goes beyond the usual deduction from capital where one year modelled  expected loss exceeds accounting provisions. The approach considered both the adequacy of provision coverage for defaulted loans, and the expected losses that were likely to emerge over a three-year period. 

The FSA examined the potential future costs that firms might incur over a three year period as a result of fines around the setting of the London Interbank Offered Rate (LIBOR) and redress payments linked to the mis-selling of payment protection insurance (PPI) and interest rate swaps. 

http://www.bankofengland.co.uk/publications/Documents/news/2013/pracappres.pdf

The most recent published figures show the Bank having a Basel 3 CET1 ratio of 7.8%, above the 7% PRA target:

http://www.bankofengland.co.uk/publications/Documents/news/2013/pracaprec.pdf

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