Kelly Report: Bad management and Britannia deal blamed for Co-op crisis

AN independent review into the crisis at the Co-operative Bank and wider Co-operative Group over the past 12 months, has blamed bad management and governance and says the Bank’s merger with the Britannia Building Society, “probably should not have happened”.

The title of the 158-page review, “Failings in management and governance” pulls no punches into the reasons for the bank’s £1.5bn financial shortfall last year, which led to the Co-op Group losing all but a 30% stake in the lender.

Sir Christopher said: “This report tells a sorry story of failings in management and governance on many levels.

“The roots of the shortfall lie in a merger between the Bank and the Britannia Building Society which should probably never have happened. Both organisations had problems. Bringing them together exacerbated those problems.”

In a swipe at Neville Richardson, the former boss of Britannia who became head of the combined Co-operative Financial Services business after the merger, he says: “It might have worked if the merged organisation had received first class leadership. Sadly it did not.

“The Co-operative Bank executive management failed to exercise sufficiently prudent and effective management of capital and risk.”

While the executive management was at fault, the board of the Banking Group  – chaired by Rev Paul Flowers – he says, “failed in its oversight” of the executive.

The wider Co-operative Group board “failed in its duty as a shareholder to provide effective stewardship of an important member asset.” he says.

The review makes fierce criticism of the “cursory” and “startling” due diligence undertaken by the Co-op Bank during negotiations between 2008 and 2009 to merge with the larger Britannia Building Society.

It says: “The cursory due diligence on Britannia’s corporate lending portfolio is startling in view of how different that lending was to the Co-operative Bank’s own business and that of comparable building societies.” 

For example the Co-op Bank’s advisor KPMG was given only limited access to Britannia’s loan book, and advice that it did provide, where it warned of the building society’s “high risk profile and large exposure to sub-prime and specialist lending”, was not seen as sufficient to stop the deal going ahead.

Sir Christopher cites nine factors for the “debacle” of the capital shortfall, which emerged last year just after the group pulled out of a deal to buy 632 branches from Lloyds Banking Group.

There were:
:: The economic environment.
:: Increasing capital requirements imposed on banks in general following the financial crisis, and on the Co-operative Bank in particular as a consequence of specific issues that it needed to address.
:: The merger with the Britannia Building Society in 2009.
:: Failure by the Bank after the merger to plan and manage capital adequately.
:: Fundamental weaknesses in the governance and management of risk.
:: Material capability gaps, leading to a serious mismatch between aspirations and ability to deliver.
:: Past mis-selling of payment protection insurance (PPI).
:: A flawed culture.
:: A system of governance which led to serious failures of oversight.

He says only the first, and partially the second factor, were outside the group’s control.

The merger with the Britannia Building Society brought with it a £3.7bn corporate loan book – mostly real estate loans – which Kelly says was “well outside” the Co-op Bank’s risk appetite.

He challenges too former Britannia and Co-operative chief Neville Richardson’s assertions over the good health of the bank’s balance sheet when he left in 2011.

“The evidence that it was not is overwhelming. The capital position only looked reasonable because problems had been pushed into the future. The risk management framework was poor. The IT re-platforming project was floundering; and there was little sign of a coherent strategy towards the non-residential mortgage portfolios inherited from Britannia other than to wait for things to get better.”

Britannia’s finances were, he states far from robust:

“The merger took place against a background of deteriorating economic conditions and falling asset prices, particularly in commercial real estate. Britannia was not as financially strong as it had been.

“In its last seven months of independence most of its profits came from a one-off repurchase of some of its subordinated liabilities and debt securities.The Regulator was sufficiently concerned about Britannia’s position to have placed it on a watchlist. Britannia was not informed of this. In July 2011 the Regulator told the Bank that it believed Britannia would not have survived without the merger.”

He highlights too that the culture of the bank was flawed too, with a “willingness to accept poor performance”,  a “tendency not to welcome challenge”, and also surprisingly, from a regional perspective a “tendency towards being in-ward-looking, arguably not helped by being based outside London.”

On the matter of the failed Project Verde deal to buy branches from Lloyds Banking Group, Kelly was critical of former group chief executive, the driving force for it:

“Peter Marks was convinced that the risks of remaining sub-scale by not doing the deal were as high as the risks of pursuing it. His relative lack of banking expertise, and his commitment to finding a way of making the transaction succeed, made a dangerous combination.”

Sir Christopher was given full access to internal papers and interviewed more than 130 current and former employees. The Review cost £4.4m to complete.

He reveals though that former Co-op Bank chairman Paul Flowers – who is placing drugs possession charges – was the “only member of the senior leadership team” to refuse to meet him.

The review into the troubled Manchester-based mutual was ordered in June 2013 by former chief executive Euan Sutherland. Mr Sutherland resigned in March after just 10 months in the role and the group has since posted a record £2.5bn annual loss.

Responding to the Kelly report findings, Richard Pennycook, interim chief executive of The Co-operative Group, said: “Following the wake-up call of our recently announced £2.5bn loss, Sir Christopher Kelly’s report today lays bare the failings of management and governance that caused it.

“It is a sobering assessment which shows clearly that The Co-operative Group’s loss of control of its Bank could have been avoided. The management that instigated this disaster for the Group are no longer in place; the flawed governance structure that failed to apply the right checks and balances, however, remains.”

Chair Ursula Lidbetter added: “Sir Christopher Kelly’s report serves as a stark reminder of the scale of change required in the governance of The Co-operative Group – something we have been clear we are already committed to.”

She concluded: “Sir Christopher’s conclusions must strengthen our collective resolve, underlining as they do the urgency of the need for far-reaching fundamental change. We must ensure the mistakes of the past are never again repeated.”

Sir Christopher Kelly is a former senior civil servant in the Treasury and now chairs healthcare charity the King’s Fund, and advisory body the Responsible Gambling Strategy Board.