Denzil Watson: Failure of ethics and leadership in Co-op crisis

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FEW commentators would have been surprised by what Sir Christopher Kelly had to say in his recent report into the near collapse of the Co-operative Bank. Even fewer would have been shocked by his assertion that the Co-op’s merger with the Britannia building society in 2009 should never have happened.

History has taught us that takeovers and mergers seldom deliver real value for the shareholders involved. Take two moderately performing financial institutions merging against the backdrop of financial crisis, regulatory changes and economic decline and you have the potential for disaster.

Despite this, the Co-op’s advisers had said the case for the merger was “compelling” while KPMG’s due diligence report described the building society’s loan portfolio to be of “high quality”. Many of those loans turned out to be toxic.

Mergers can offer potential gains, but these are far easier to talk about than they are to realise. The loose logic underpinning the deal was it gave the bank the ability to tap into Britannia’s network of 258 branches, while Britannia would gain access to Co-op Bank’s current accounts and internet banking channels.

It was estimated that savings of £88m a year would result – a hefty amount given that the Co-op Bank’s profits averaged just £67m three years prior to the merger. However, the formation of the new “super-mutual” left Co-op Bank with more than it could handle risk-wise owing to Britannia’s £3.7bn commercial lending portfolio. about £1.8bn of this was high risk commercial property lending, well outside of the bank’s risk tolerance levels.

Clear strategic planning and strong management from experienced senior executives is essential in driving the post-merger integration process. The Co-op Bank failed spectacularly on both fronts. Lines of managerial responsibility between the Co-operative Group’s board and the bank’s board were ill-defined. It also suffered from an inability to identify, recruit and appoint senior management of appropriate calibre and also fell short when it came to electing appropriate non-executive directors.

The result was that inexperienced managers presided over a complex business on a scale well beyond their capabilities. Methodist minister Paul Flowers, the former Co-op Group deputy chairman, was appointed non-executive chairman of the bank in 2010, despite having no senior banking or financial services experience.

Other senior staff sitting on over-inflated salaries were equally inexperienced. Neville Richardson, Britannia’s ex-CEO, was installed as the enlarged entity’s chief executive officer, despite having no previous experience of running a bank.

That same lack of experience also proved costly when it came to integrating the two businesses’ IT systems. The budget for this project was set at £184m but had soared to £349m by the time the decision was made to scrap it and start afresh, leading to a further outlay of £500m.

The upshot of all this was painfully predictable. The new bank suffered from poor management that was either unaware of or unwilling to deal with the many issues facing it.

They failed to engage with their regulator in a constructive way and chose, instead, to ignore critical capital and risk issues in a business culture that too easily accepted mediocrity and lacked accountability.

Sir Christopher’s report was also critical of the Co-operative Group’s board which “failed in its duties as shareholder to provide effective stewardship of an important member asset”. The group’s CEO Peter Marks came in for particular criticism.

And the problems are still there. This week’s review of the group by former City Minister Lord Myners concluded that its current board is “manifestly dysfunctional”. He said it must adopt a much smaller board and focus on being profitable in order to survive.

There were other problems too. The bank’s ethical credentials were sullied by its announcement in 2010 that it was having to set aside monies to compensate customers who were mis-sold payment protection insurance. By last year the amount had risen to £347m.

Things finally came to a head in May last year when a £15bn capital “black hole” was discovered in the bank’s balance sheet and Moody’s downgraded the bank’s credit rating to “junk” status.

The resulting crisis saw the resignation of senior management, including the disgraced Flowers. Having presided over a radical restructuring programme that saw the group cede 70 per cent of its ownership of the bank to US hedge fund investors, new chief executive Euan Sutherland resigned in March this year, stating that the organisation was “ungovernable”.

The sad thing is that none of the lessons from this debacle are either new or particularly complex. The only positive to be gleaned is that Co-op Bank didn’t go under and may, in time, make a full recovery. But the lessons detailed in the reports by both Sir Christopher Kelly and Lord Myners must be acted upon.