Paul Gosling: Project Verde – the Lloyds’ branches acquisition

Bye bye Verde

The Co-operative Group’s decision to withdraw from the purchase of 630 Lloyds Banking Group branches is not entirely surprising.  Several problems about the deal had surfaced in recent months and there has always been anxiety behind the scenes.  The banking operation would have trebled in size and if the deal had gone badly wrong, it threatened more than just the banking side of the business.

One well publicised problem has been the need to improve the capital base of the Co-operative Banking Group.  According to the Financial Times, an additional £1bn was needed to satisfy regulators – previously the Financial Services Authority, now the Prudential Regulation Authority.  Regulators are not saying how much would be needed, though it would probably have been much less than that in the end – though it would still have been a big figure.

Some commentators suggested that the Lloyds’ branches acquisition – the deal was called Project Verde – would actually have improved the Co-op’s capital position.  But that may not have been sufficient to satisfy regulators.  It does, though, underline the point that the Co-op still has to raise extra funds to satisfy the PRA.

The two deals to sell the insurance businesses will still go ahead.  The sale of the life business to Royal London is almost complete.  And the proposed disposal of the general insurance business will proceed.  Motivation for these sales is to focus on banking, not simply to raise capital.  However, the £200m from Royal London and a sum that may be in the region of £650m for the general insurance business should at least help with regulators’ capital anxieties.

Capital demands help to explain why the Co-op has reduced net lending in recent months.  According to the Bank of England’s figures, the bank reduced its net lending in the second half of last year by £399m – not a big figure given total lending of £32bn, but a reduction nonetheless.  (The Bank of England shows end of 2012 lending at £32bn: the Group’s balance sheet reports it as £33.4bn.)

Another growing concern is the challenge of post-merger integration.  The integration of Somerfield has been difficult for the Group.  Nor has the takeover of Britannia Building Society been free of problem.  Britannia engaged in some higher risk activities during the boom, including buy-to-let mortgages, which were the main reasons for write-downs of £377m, compared to a profit in the core banking operations of £120m.

Despite the Britannia’s legacy losses, the Group continues to believe the takeover of the building society was justified and correct.

There was also a write-down of £150m in the last accounts on the value of the Co-op Banking Group’s IT system.  The rationale for this was that the IT system would not be needed, and was not of sufficient scale, once the Lloyds acquisition was completed.  The enlarged bank was to use the Lloyds’ system.

Interestingly, there is no intention to now write back up the value.  When the IT system was acquired, the bank regarded it as state of the art and offering real value in offering better cross-selling opportunities.  But with the disposals of the insurance businesses, the bank is focusing on core banking and mortgage lending – so the IT system is anyway worth less to the bank today than it paid.

The Britannia acquisition has made the bank bigger, but it is much smaller than it would have been with the Lloyds’ branches.  The highly respected business editor of the BBC, Robert Peston, speculated immediately after the deal collapsed that the Co-op may leave the banking sector altogether.  I am assured this is absolutely untrue.

Co-operative Banking Group will continue in operation and it will grow, but at a gradual and sustainable pace.  It will focus on organic growth, while still being interested in taking over some smaller building societies where these present a sensible geographic fit to assist with expansion.

This approach offers a much lower risk than proceeding with Project Verde – and this is the key reason for the decision.  The risk to reward ratio has swung against the deal in recent months.  Scale is one thing, but it has to generate profits – and these were in doubt.

The continued recession has led to projections of very weak growth for the rest of the decade.  That reduces demand for financial products.  Moreover, interest rates will stay low for many more years.  Low interest rates mean low margins for banks and that translates to low profits.  In this instance, extra scale would not generate commensurate profits for the Group.

Moreover, there have been growing concerns about the value of the acquisition in other terms.  Just how many of the extra customers would accept the transfer to the Co-op?  Nothing would prevent them simply transferring back to Lloyds – and it is becoming increasingly easy to transfer banks.

And there were doubts whether it makes sense to take this level of risk to buy a large branch network, when ever fewer people use bank branches and the Post Office is taking over many more simple branch banking transactions for a range of banks, including the Co-op.  Smile has consistently been a very successful internet only operation for the Co-op.  The decision by RBS to focus more on small and fully automated branches is another sign of current trends regarding branch banking.

There were fears, too, that the Lloyds acquisition would deflect management attention from the focus on high quality customer service.  The latest figures on complaints published by the new regulator for individual financial institutions, the Financial Conduct Authority, placed the Co-op in ninth place.  This was not bad for the sixth largest UK bank, but not especially brilliant.  It is another indicator of the difficulties caused by the mis-selling of Payment Protection Insurance – itself another cause for the loss reported for last year.

The key point to understand is that the Bank remains positioned where it was: a player, but not a market leader.  Moving from here to there was just too big a risk.  While I am disappointed, I am also relieved – it was a very big risk.

The change in direction may reflect not just the continuing economic conditions, but also the difference in personalities and risk appetite of the outgoing and incoming chief executives.  Peter Marks had gained a reputation for doing deals such as Somerfield, Britannia and Thomas Cook that grew market size.  We shall have to wait to see if his replacement, Euan Sutherland – who takes over this month – is more focused on consolidation than expansion.

The last word, then, should go to Peter Marks.  “After detailed and thorough consideration of all aspects of the Verde transaction, we have decided, at this time, that it is not in the best interests of our members to proceed with the transaction. …. the Verde transaction would not currently deliver a suitable return for our members within a reasonable timeframe and with an acceptable level of risk….. we will continue to develop our Bank for the long-term, offering a real alternative on the high street with our strong, established brand and our reputation as a trusted financial services business.”

So be it.

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