THE FUTURE OF BANKING COMMISSION

Introduction

1. The Building Societies Association (BSA) represents mutual lenders and deposit takers in the UK including all 52 UK building societies. Mutual lenders and deposit takers have total assets of over £390 billion and, together with their subsidiaries, hold residential mortgages of almost £260 billion, 21% of the total outstanding in the UK. They hold over £250 billion of retail deposits, accounting for just under 23% of all such deposits in the UK. They employ approximately 50,000 full and part-time staff and operate through approximately 2,000 branches.

2. This submission looks at the overall position of the mutual sector, answering a number of the questions in the “Areas of investigation” note published by the Commission, and then looks at the current business conditions faced by building societies.  The Association would be pleased to provide more detail on request, either in writing or in oral evidence.

The Contribution of Mutuals – the Long-Term Case

3. The general failures of the banking system, and in particular the failure of any of the former building societies that demutualised and converted into banks in the late 1990s to sustain their independence, has focused attention on whether a re-examination of the distribution of businesses between the plc and mutual structures might be beneficial.  Both the Labour[1]  and Conservative[2] parties have recently taken policy initiatives to examine the contribution that mutual and co-operative structures might make in wide areas of corporate life (including outside the banking sector).  Among the motivations for such initiatives, as far as can be determined by the Association, are to look at structures that can potentially increase competition, reduce risk, increase diversity, improve accountability and improve both consumer and employee trust in institutional structures.

4. This first part of the Association’s submission examines the case for mutual institutions in the financial services market and is structured around the themes mentioned above –

• Bio-diversity
• Lower risk appetite
• Competition
• Democracy
• Service and trust
• Long-term perspective

Many of these points are relevant to the questions raised in the “Areas of investigation” document

(i)   Bio-diversity

5. There has been a significant debate about the value of diversity – that is different types of institutions competing with each other in a particular market.  One of the best analyses is by Andrew Haldane, Executive Director, Financial Stability, at the Bank of England.  In his speech Rethinking the Financial Network in April 2009[3], he compared the financial services market to various ecological systems.  He pointed out that diversity within the finance system diminished sharply in the run up to 2007.  The reliance on the principles of Basel II, the predominance of the ratings agencies, the growth of Value at Risk models and associated stress testing, and the strong trend towards demutualisation all added to the homogeneity of the system.

6. Following an analysis of these factors and comparing them to the collapse of various fish-based ecosystems in the previous 20 years, Mr Haldane went on to say –

"In explaining the collapse in fish and finance, lack of diversity seems to be a common denominator. Within the financial sector, diversity appears to have been reduced for two separate, but related, reasons: the pursuit of return; and the management of risk. The pursuit of yield resulted in a return on equity race among all types of financial firm. As they collectively migrated to high yield activities, business strategies came to be replicated across the financial sector. Imitation became the sincerest form of flattery.

So savings co-operatives transformed themselves into private commercial banks. Commercial banks ventured into investment banking........

Finance became a monoculture. In consequence, the financial system became, like plants, animals and oceans before it, less disease-resistant. When environmental factors changed for the worse, the homogeneity of the financial ecosystem increased materially its probability of collapse."

7. A substantial market share for mutual institutions adds to the diversity of a financial system, whereas a plc mono-culture increases the danger of herd instincts developing.  Mutuals bring organisational and regional diversity and add to the richness of the financial services landscape, while reducing (but certainly not removing) the likelihood of all financial institutions behaving in the same (in recent years, wrong) way in a given set of financial conditions.

(ii)  Lower Risk Appetite

8. Every institution that lends money runs a risk that it will not be paid back.  There is much debate in the mortgage market about how to measure risk.  There are plenty of examples of lenders carefully lending on high loan to income ratios or high loan to value ratios and not suffering a sharp increase in arrears.  The risks of lending to those with dubious credit histories can also be ameliorated by careful underwriting. 

9. Despite the difficulties of the Dunfermline Building Society, mutuals have generally exhibited a lower risk appetite than their competitors.  For example, building society mortgage arrears are (proportionately) less than two thirds of those for the market as a whole.  On the other side of the balance sheet, building society wholesale funding peaked at just 30% of their total funding; much lower than that for many banks.  Building societies have always relied on the generally safer collection of retail deposits rather than what has been seen as the easily interrupted flow of wholesale funding.  Moreover, building societies are legally barred from taking positions in the derivatives, foreign currency or commodities markets (ie they are forced away from the “casino” banking model towards the “utility” model by legislation).  Building societies had little or no exposure to the American sub-prime market, to collateralised debt obligations, to structured investment vehicles or all the other adventurous areas into which their banking counterparts ventured. 

(iii)  Competition

10. The Government has a policy objective of “encouraging choice and competition” in financial markets.  One way of doing this, according to HM Treasury’s White Paper Reforming Financial Markets[4], of July 2009 “is to encourage and support alternative business models” such as mutuals.

11. Building societies have a natural advantage over plcs in that they do not pay dividends to shareholders and can use the funds thus released to pay higher savings rates, offer lower mortgage rates or enhance service standards.  Building societies regularly top the best buy tables, notably those tables that look at consistency of returns to savers over longer periods.  The latest (January 2010) statistics from Moneyfacts, for example, showed that for consistent paying savings accounts (over 18 and 36 months, rather than for accounts that are best buys for a week or two and then suffer sharp interest rate cuts) building societies take 72% of the top places. This sort of performance puts pressure on the banks to respond.  Similarly pressure from building societies to maintain free access to ATMs early in the last decade made it more difficult for the banks to implement a policy of imposing ATM withdrawal charges.

(iv)  Democratic Engagement

12. Not only do mutuals tend to provide the best returns to their members, they also exhibit greater accountability to their customers.  This is not surprising.  Banks are accountable to their shareholders.  Those shareholders demand a rising share price and growth in dividends (although those demands have not been met over the last two years!).  Mutuals are not under that pressure.  They are, however, under the pressure that they are collectively owned by their customers, and this has an impact on the way building societies behave.

13. Many societies have, for example taken initiatives to ensure that voting turnout at annual general meetings has increased sharply over the last decade.  Many building societies hold road shows where directors meet members on a regular basis.  A number of societies also have member panels, or member councils who they invite to take a greater interest in the way the business is run.

14. Perhaps most importantly, given the feverish debate about bankers’ pay and bonuses, building societies voluntarily allow members to vote on directors’ remuneration reports at the time of the AGM.  Societies regularly obtain 90% approval (among those voting – typically around 20% of the total membership) for these reports suggesting a lack of member concern about the level of building society executive and non-executive pay, in contrast to the banking sector, where it is scarcely credible that a vote of customers on the subject of bankers’ pay would reveal the same degree of support!  Mutuals’ accountability to “the man in the street” has kept their feet on the ground in this area, while banks had, and have, their heads in the clouds, divorced from the popular distaste of their remuneration practices.  Much more information on societies’ policies in this area can be found in the Association’s publication Conversations with Members: Member Engagement at Building Societies published in January 2010[5].

(v)  Service and Trust

15. A further feature of mutuals is that their service levels are perceived as better by their customers than customers perceive the service standards of banks.  Research undertaken for the BSA at the end of 2008 (and currently in the process of being repeated) shows much greater levels of customer satisfaction in both savings and mortgages provision and markedly better perceptions of fairness, trust, value for money and willingness to recommend to family and friends than in the banking sector.  Much more detail is in the Association’s publication Building Societies: Providing a Better Customer Service[6].

16. This is not surprising.  When building society staff serve a customer they know they are serving one of the collective owners of their organisation.  This gives a quite different customer relationship than in a shareholder driven organisation. 

(vi)  The Long-Term Perspective

17. The argument for mutuality (and, indeed, for remutualising former mutuals that struggled to last a decade in the plc sector) is one of long-term thinking.  Savings and mortgages are long-term products, while trust and relationships can be built up only over a long period of time.  These products and concepts are less suitable for those firms that are subject to the short-term pressures of rapidly gyrating financial markets, share prices and dividend payments.  There is a conflict between building longer-term business success while at the same time being integrated in a system that increasingly looks to short-term measures as an indicator of performance.

18. This section started with a quote from Andrew Haldane from the Bank of England and it finishes with one.  The following comes from Mr Haldane’s presentation to the Association of Corporate Treasurers in Leeds on 14 September 2009 –

"Mutuality may do a better job of aligning stakeholder incentives than some alternative forms of corporate governance. It is a depressing but telling fact that, of the demutualised former UK building societies, none is today in independent ownership. [Two (Northern Rock and the mortgage business of Bradford & Bingley) have been nationalised.  Three (Abbey National, Alliance & Leicester and the savings business of Bradford & Bingley) are owned by a Spanish bank.  The Woolwich is a brand owned by Barclays. Halifax, Cheltenham & Gloucester and Birmingham Midshires are now part of the Lloyds Banking Group, a significant proportion of which is owned by the UK Government, while the Bristol & West mortgage brand (owned by Irish Government-supported Bank of Ireland) has disappeared, the savings business having been remutualised by Britannia Building Society in 2005.]  Thrift, mutuality and relationship building have long underpinned banking in Yorkshire. These principles went missing in the run-up to the present crisis. The costs of that vanishing act are now all too apparent. In rebuilding the financial system, to create one which is both stable and better able to meet the needs of the real economy, these principles need to be rediscovered. They offer a tried and tested - indeed, trusted - roadmap for the period ahead."

[Information in square parentheses added by the BSA.]

19. The continued and growing success of mutual institutions offers the UK financial services market the opportunity to build on the sector’s already substantial achievements.  The prizes are very substantial – a growth in diversity, competition, customer service, democratic accountability and trust, with a reduction in risk.  One can cling to the failed experiment of the last few years or return to the “tried and tested – indeed trusted” efforts that served the UK consumer so well in the previous 150 years.  The promotion of mutual institutions by the Commission would be a strong, positive statement that the lessons of the last dozen or so years were being learned.

Short-Term Issues

20. Despite the undoubted merits of the mutual model, building societies, like other institutions, are finding current market conditions challenging:

• very low interest rates have drastically reduced individuals’ incentive to save in the form of deposits, restricted the flow of funds to the mortgage market; and squeezed building societies’ margins; the size of the UK deposit and mortgage markets have fallen markedly, in 2009 especially;
• this has been exacerbated by the freezing of wholesale markets, from which the building society sector derives a significant, although declining, minority of its funding;
• requirements to finance a disproportionate share of the Financial Services Compensation Scheme liabilities arising from the bank failures of late 2008 have reduced building society profits significantly.  Building societies fund themselves mostly through relatively safe retail deposits; nevertheless those institutions that fund themselves through riskier forms of wholesale funding, but with a relatively small deposit base, pay proportionately less into the FSCS
• the conflicting regulatory and political pressures to increase capital, increase liquidity and to lend more;
• societies face unfair competition from the range of fully nationalised and majority Government-owned banks;
• building society access to Government schemes, such as the Credit Guarantee Scheme and the Asset Protection Scheme is either not available to societies or available on much more onerous terms than for banks;

21. Building societies have performed relatively well during the recession.  This is a view not only of societies themselves, but of both the FSA and HM Treasury.  The FSA said in June 2009, for example, in A Specialist Sourcebook for Building Societies: Enhanced Supervisory Guidance on Financial and Credit Risk Management [7]  –

“Although building societies, like banks, have been weakened by adverse economic and financial market conditions, the extent of that weakening has to date been less than that experienced by the banks – mainly because of the lower exposure to wholesale funding and complex financial instruments.”

22. Similarly, HM Treasury expressed the view in its White Paper Reforming Financial Markets published in July 2009 that –

“The mutual sector has not been immune to the pressures caused by the contraction of global credit markets and the crisis that has ensued, particularly for those firms diversifying into new and high risk lending products – it is the Government’s view, however, that the traditional mutual model has, on the whole, stood up well.”

23. Overall, building societies pursued less adventurous lending policies than their competitors in the mortgage market in the run up to 2007 and their arrears figures are significantly less, proportionately, than the average for the mortgage market as a whole (and building societies remain committed to helping those in arrears in every way they can, viewing repossession as the very last resort in the vast majority of arrears cases).

24. Despite this building societies, like other institutions, are finding current market conditions challenging.  In particular, there is now a very limited flow of funds through the principal markets in which building societies operate.  In 2006 deposit balances across all banks, building societies and National Savings & Investments rose by £77 billion.  In 2009 this figure was just over £30 billion with much of this accounted for by interest credited to accounts – in other words, on a net basis, individuals are putting little new money into their cash savings.  The BSA warned early in 2009 that very low interest rates would drastically reduce the incentive to save, and restrict the flow of funds to the mortgage market – unfortunately this prediction has proved to be correct.

25. In the UK mortgage market in 2006 net advances (ie advances after taking account of repayments) amounted to £110 billion.  In 2009, the figure was around £12 billion. 

26. Profitability is also sharply diminished.  In 2008 building societies collectively made a profit of 19 pence for every £100 which they managed.  (Figures for 2009 are currently being announced by societies.)  Over the previous few years the figure had been very stable at around 33 to 36 pence for every £100 of assets.  The figures for 2008 were adversely affected by reduced interest rate margins, lower sales of insurance products (reducing the flow of commission payments) some provisions for loss, and notably, provisions for payments into the Financial Services Compensation Scheme, as building societies bore a significant proportion (as noted above) of the costs of bailing out the failed Bradford & Bingley bank and the failed Icelandic banks.  Similarly, the mainstream banking sector is also suffering a sharp reduction in profitability.  Profits of the biggest four UK banks (HSBC, Barclays, Lloyds Banking Group and RBS) fell by 78% in their UK retail banking business between the first halves of 2008 and 2009.  (Source: bank half yearly statements, analysed by KPMG in UK Banks: Performance Benchmarking Survey, Half Year 2009, page15[8] . Again full year 2009 figures are currently being announced).

27. Building societies (and banks) also suffer from conflicting pressures to increase capital, increase liquidity and to lend more (when funding markets are effectively closed).  These ambitions are not compatible. 

28. In particular, building societies now have to place between 20% and 25% of the funds they raise in liquidity; (whereas in the prior two years the average liquidity ratio was less than 19%) similarly, banks have been required by the authorities to increase the proportion of liquid assets that they hold since the crisis began.  This has the desirable objective of making banks and building societies more resilient to any future funding crises.  However, those funds allocated to liquidity cannot simultaneously be lent to customers, be they homebuyers or businesses.  The structure of interest rates also means that societies earn less on their liquid assets than they pay to acquire these funds from savers.

29. Similarly, banks and building societies are under pressure to hold increased levels of capital to cover the possibility that they might make further losses on the loans which they currently hold, or might hold in the future.  Capital ratios can be increased, most obviously, by restricting the growth of the balance sheet and ensuring that any growth that does take place is concentrated on extremely low risk lending, which requires less of a capital buffer against the possibility of loss.  This is achieved in the mortgage market, for example, by asking borrowers for large deposits and not lending to individuals with even the slightest blemish on their credit records.  Falling house prices increase the potential losses that might be made in the event of repossession and again this trend again requires consideration of additional capital.  Any institution considering ignoring these trends and increasing riskier lending faces the possibility of being downgraded by the credit-rating agencies, thus reducing the supply of wholesale funding further, increasing the cost of those funds that are available, and suffering a declining reputation in the retail market.

30. At the same time building societies face intense, and we believe, unfair competition from the range of fully nationalised or majority Government owned banks, together with National Savings & Investments, all of which are perceived to have explicitly or implicitly a total Government guarantee.  Furthermore, the Government’s Debt Management Office is replacing building societies (and banks) in the wholesale market.  Local authorities especially used to lend significant sums to building societies (and banks) but have been withdrawing deposits from both sectors.

31. Access to Government schemes such as the Credit Guarantee Scheme (CGS) is either not available to building societies or is available on much restricted terms. The CGS can be used to obtain a Government guarantee only for issues of specific debt securities.  But many building societies do not issue debt securities as their funding volumes do not justify the issue overheads – instead they take term deposits from the money market and provide a home for local authority temporary cash surpluses. The CGS would have been the ideal vehicle to provide, in the short term, the additional reassurance that local authorities needed, but because of its restrictive design features it could not be used and this has contributed to a large outflow from building societies of local authority deposits.

32. Where societies are able to access the CGS they are required to pay more than the banks. Nationwide Building Society, for example, has pointed out that, last autumn, it was required to pay 65% more than the Lloyds Bank Group pay to access the CGS and an estimated 35% more than Royal Bank of Scotland.  All other societies that qualify for the CGS were required to pay even more than Nationwide.

33. Finally, it is important to bear in mind that all banks and building societies are different; not all are affected by the factors described above equally.  The vast majority of building societies remain profitable, and will survive the current difficult environment.
Conclusion.

34. This paper has shown the long-term value of mutual institutions to the UK financial services market.  Building societies and other mutuals provide a valuable alternative to mainstream plc banks, offering high service standards, a long-term perspective, democratic accountability to customers, and competitive pricing.  Despite the short term challenges they face in the current difficult market conditions the Association is confident that its members will continue to exhibit strong performance for many years into the future.

• Policy
• |
• Consumers
• |
• Media Centre
• |
• Publications
• |
• Events
• |
• Membership
• |
• Site Map
• |
• Contact Us
• |
• Website T&C's

© 2011 The Building Societies Association (BSA)