Changed financial world offers opportunities for mutual sector

The two-day Building Societies Association annual conference in Manchester, which brings together directors and professionals from across the mutual sector, will reflect on one of the toughest periods the industry has faced.

The latest wave of consolidation is still working its way through the sector, and more mergers are expected among the UK's 51 remaining building societies.

Mutuals are operating in a market distorted by the lowest interest rate in the 316 year history of the Bank of England. Despite this, the cost of wholesale funding remains high.

Competition is fierce, as they fight for custom with bailed out banks offering attractive interest rates. Meanwhile, increased bad debts continue to put pressure on balance sheets.

"This year's conference takes place against a background of unprecedented change in, and challenges for, the building society sector," said BSA director general Adrian Coles.

Add these hurdles to the cost of bailing out Bradford & Bingley and protecting savers exposed to failed Icelandic banks, and he said "it is perhaps not surprising that societies have at times found it difficult to take advantage of the difficulties facing the banking sector".

But despite this, Mr Coles said the sector "remains in good heart". With the exception of the failed Dunfermline Building Society, the sector has broadly looked after its own, with stronger mutuals taking over weaker rivals.

Yorkshire Building Society recently completed its merger with the Chelsea, creating the UK's second-biggest mutual with 35bn in assets. Chelsea had been heavily loss-making for the past two years.

Chief executive of the Yorkshire, Iain Cornish, said: "We are likely to continue to see consolidation and restructuring in the sector. I don't think consolidation per se is vital, but it's important that the sector comes through in good shape.

"It's possible for societies of all shapes and sizes to thrive."

Among the key talking points at the conference will be shared services and cost control, as societies look to bolster lower profits with better efficiency.

"It's absolutely critical for us to be very efficient and reduce running costs," said Mr Cornish, whose organisation provides computer services to Leeds Building Society. "Running shared central systems... is an alternative to mergers."

Building society expert Adam Bennett at law firm Addleshaw Goddard said a big challenge this year will be on the struggle to maintain interest rate margins – the balance between what they earn in mortgage lending and what they pay out on savings.

The ultra-low interest rate environment means for many mutuals, this margin has been squeezed hard.

"The focus for 2010 will be trading profitably," he said. "Some societies, like the Coventry and the Leeds, have done a lot to cut their costs – that's an essential thing that people should be doing."

Addleshaw Goddard advises 30 of the UK's 51 mutuals, and has worked on mergers, capital raises and restructuring.

"There may be a small number of mergers going forward but I think the societies that are going to be in difficulty have worked their way through the system," said Mr Bennett. "I'm confident that the sector is in reasonably good shape to face the challenges that are still there."

Mr Cornish said mutuals now have the chance to capitalise on public dissatisfaction with banks, by offering a simple alternative.

"There are huge opportunities to differentiate ourselves from the banks," he said. "People trust us more and they get better service from us.

"The legacy of mistrust in what the banks have done is going to linger for a long time. For me that's a real, material opportunity."

Unlike banks, mutuals do not pay dividends and instead reinvest profits into savings and mortgage rates.

Many are wedded to their communities, and like the Beverley Building Society, have plotted a profitable way through the past year by relying on local loyalty and knowledge.

"I'd expect the conference to be a bit more upbeat than last year," said Phil Gray, chief executive of the Beverley, one of the UK's smallest mutuals. "2009 was generally a more stable set of results in the sector.

"Last year was really one of consolidation and saying times are a tough so we need to be sensible about what people are doing and get back to basics."

NEW RULES ON CAPITAL HOLDINGS

The Treasury is consulting building societies on their capital needs as it looks to strengthen the sector.

It has launched a discussion paper on the capital they hold – the financial cushion used to absorb losses in a crisis.

Lower profitability at building societies has led to capital levels coming under strain, as retained profits make up about 85 per cent of the sector's capital. The Financial Services Authority has laid out plans for tough new rules on the levels and types of capital mutuals must hold. The FSA wants to narrow the type of capital which contributes to mutuals' core tier one ratios – a key measure of their financial strength. The discussion paper also recognises the need for a new core tier one capital instrument, which would allow building societies to boost capital. Yorkshire Building Society, in its merger with Chelsea Building Society, created a type of instrument never seen before in the sector.