NTSB, Coop Bank

My two interests of air crash investigations and financial systems are coinciding today as I read through the Coop Bank annual results. Unlike RBS’s decline in 2008, this isn’t a dramatic story of poorly understood risk lurking behind complex financial instrument, it’s a bit more straightforward. But, since I spent some time picking through the numbers I thought I’d capture it for posterity.

A traditional high-street bank makes money from loans because customers have to pay interest on their mortgages and car loans, hence banks consider loans to be assets. The money which you or I have in our current or instant-access saving accounts, “demand deposits”, are liabilities of the bank. The bank pays out interest to savers. Unsurprisingly, the interest rate on loans is higher than what the bank pays to savers, and the difference (called “net interest income”) is income for the bank which ideally helps increase the banks equity (ie. money owned by the bank, which shareholders have claims on).

At first glance, Coop Bank are doing fine here. They have £15.3bn of loans to people (14.8bn) and businesses (0.4bn). They have £22.1bn of customer deposits [page 16], spread fairly evenly between current accounts, instant savings accounts, term savings accounts and ISAs, being a mixture of individuals (£19.4bn) and companies (£2.7bn). A quick check of their website shows they pay savers around 0.25%, and mortgage rates around something like 3%, which directly gets you to their “net interest income” of £394m from their high-street (aka “retail operations”). So that’s a big bunch of money coming in the door, good news!

(They used to be big into commercial property loans, but by 2014 their £1650m of loans included about £900m which were defaulting, and they sold off the rest and got out of that business)

But every business has day-to-day costs, like rent and staff salaries to pay. Staff costs were £187m which sounds like a lot of money, but a UK-wide bank has a lot of staff – 4266 [page 33] of which 3748 were fulltime and 1018 part-time. That’s an average of £43k each, but it’s not spread evenly – the four executive directors got £4172k between them [page 92], and the eleven non-exec directors got £1052k between them [page 95]. In addition, they paid £121m on contractors [page 178]. So, total staff costs were £300m. Hmm, now that £394m income isn’t looking so peachy. We’ve only got £94m left – let’s hope there’s nothing else we have to pay for.

Oops, forgot about the creaking IT infrastructure! The old IT setup was pretty bad it seems. The bank themselves warned investors in 2015 that “the Bank does not
currently have a proven end-to-end disaster recovery capability, especially in the case of a
mainframe failure or a significant data centre outage.” (page 75). The FCA (Financial Conduct Authority) who regulate banks and check that they are at least meeting some basic minimum standards told the Coop Bank in 2015 that they were in breach of those basic standards. So, they came up with a cunning plan to get off their clunky mainframes and onto a whizzy IBM “managed service platform” which, one would hope, is much shinier and has a working and tested backup solution. All of this “remediation” work wasn’t cheap though, clocking in at £141m for the year. The good news is that the FCA are all happy again and it should be a one-off cost, but we’re looking at loss overall for the year of £47m.

But we’re not done yet! We also have some “strategic” projects on the go, which managed to burn £134m [page 19]. A while back, Coop decided to “outsource” its retail mortgage business to Capita, and then spent a lot of time bickering with them, before finally making up this year. Nonetheless, a planned “transformation” of IT systems is getting canned, the demise of which is somehow costing the bank £82m! At the more sensible end, £10m went into “digital” projects, which I assume includes their shiny new mobile app [page 12]. But all in all, those “strategic” projects means we’re now up to a £181m loss.

Only one more big thing to go. Back in 2009, Coop Bank merged/acquired Britannia Building Society, gaining about £4bn of assets in the form of risky commercial property loans, and some liabilities. Those liabilities included IOUs known as Leek Notes which Britannia had issued to get money in the short-term. When Coop acquired Britannia, there was some accountancy sleight of hand done to make the liability look smaller [page 26 in Kelly Review] but nonetheless a £100 IOU still has to ultimately be paid back with £100, and so now Coop Bank is drudging through the reality of a paying back (aka “unwinding”, gotta love the euphemisms) a larger-then-expected liability. In 2016, that was to the tune of £180m.

So now we’re up to a £361m loss. Chuck in a few more projects like EU Payment Directives, some “organizational design changes” which cost £20m and you get to a final overall loss for the year of £477m.

Now, in the same way that I (as a person) can have money that I own in my pocket, Banks can have money that they (as a company) own – which is their equity. In good times, some of that equity gets paid out to shareholders as a dividend, and some is retained within the company to fund future growth. But in bad times, that equity is eroded by losses. Coop Bank started the year with about £1100m of (tier 1) equity, and the £400m loss has chopped that down to £700m. If you’re losing £400m in a year, £700m doesn’t look like a lot of runway and that’s why they’re trying to sell the business or bit of it, or raise equity by converting bonds to shares or issuing bonds.

Like any business, you’ve got to have more assets than liabilities otherwise your creditors can have you declared insolvent. And Coop Bank certainly has more assets than liabilities. But the loans which make up part of the banks assets are fairly illiquid, meaning they can’t be readily turned into cash. Furthermore, they’re somewhat risky since the borrower might run away and default on the loan. So, in order to be able to soak up defaulting loans and have enough money around to people to withdraw their deposits on demand, banks need to have a certain level of equity in proportion to their loans. You can either look at straight equity/assets, aka leverage ratio, which is 2.6% for Coop Bank (down from 3.8% last year). Or you can do some risk-weighting of assets, and get the Tier 1 Capital ratio of 11% (down from 15%). The Bank of England says that “the appropriate Tier 1 equity requirement …be 11% of risk-weighted assets” so Coop Bank is skirting the edges of that.

All in all, if interest rates stay unchanged and Coop Bank’s loans and deposits stay where they are, then you could imagine a small profit from net interest income minus staff/related costs. But the burden of bad acquisitions, failed integration projects and massive IT overhauls are overshadowing all of that and that’s what’s put Coop Bank where it is today.