Key issues facing mutual banks - and examples of what NOT to do
This article from corporate governance expert Nigel Kendall explores the challenges faced by mutuals in today's financial landscape and the implications of inadequate risk management and governance structures.
Mutuals are companies owned by their customers or members, with profits distributed based on each member's business engagement with the mutual. Examples include co-operative societies, credit unions, building societies, and friendly societies listed on the UK's Mutuals Public Register. Insurance companies were among the earliest forms of mutuals, focusing on risk-sharing through member contributions.
In mutuals, elected representatives look after the members' interests. They form committees that choose the top officials responsible for running the company. While the company's executives usually make decisions on their own, members may have trouble influencing the company if something goes wrong.
This kind of structure is not without issues. The elected representatives might have personal or political interests that affect their decisions. They might not have the right qualifications to make important choices. Mutuals usually rely only on money from members, so they have limited options for getting more money for investments or other needs.
These challenges have had adverse effects on several mutuals, with three examples below demonstrating the potential for damage caused - sometimes resulting in fatal consequences.
1. Equitable Life Assurance Society
Equitable Life was one of the oldest mutual societies, founded in 1762, and by the middle of the 1960s had established itself as a top-quality savings organisation. Over the next few decades, however, as the market evolved and competition increased, it started inventing new and more sophisticated products. This worked well initially, but as the growing markets were periodically interrupted by financial storms, a new policy was adopted to give flexibility in meeting promised returns. This policy involved flexing terminal bonuses to protect total returns, but the details were hidden in complexity. It was several years before the Board had any notification of the changes, and it was never made clear to policy-holders.
The findings of an Enquiry into Equitable Life in 2004 by Lord Penrose found that the balance of assets available to meet forecast claims started to go negative from the early 1990s, and within a few years the Board decided it had to cut the terminal bonus on the product called Guaranteed Annual Rate (GAR). This triggered a law-suit by a policy-holder, on the basis that this action broke the implied guarantees in the policy contract, and in 2000, the House of Lords, in Equitable Life Assurance Society v Hyman, decided against the insurer. The consequence was the near-collapse of Equitable Life, which didn’t have the liquid funds to pay the resulting £1.5bn annuity liabilities, and this once-respected 260 year-old business had to sell assets and close to new business.
Lord Penrose’s Report was damning in its findings. Key points raised were:
The mutual was under-funded by £4.5bn in summer 2001, resulting from over-allocation of bonuses; the surpluses justifying these pay-outs were generated by the extreme use of actuarial techniques.
The first attempt by the Board to even approach the issue of product risk was the establishment of an Audit Committee in 1994, and it didn’t start to look at product risk until 1997, by which time it was too late to avert the growing disaster.
Internal Risk committees didn’t monitor product and liability risks to any great extent, and the Board was provided with little relevant information to be able to understand the growing risks.
None of the Non-Executive Directors had relevant skills or actuarial experience over the relevant period; the ones with financial experience came from banking and investment backgrounds.
Executives with actuarial experience had to defer to the chief Actuary and didn’t attempt to challenge the growing risks.
The Board delegated responsibility for policy drafting and development to the Actuary.
In short, the interests of the mutual policy-holders were not competently looked after by the Board which was supposed to be protecting their interests, the management was run by an autocratic CEO who was also Chief Actuary with fatally inadequate risk management, and when a representative of the members challenged the board and won his case, it brought the roof in.
2. Co-operative Group and Britannia Building Society
The Britannia Building Society, originally founded in 1856, grew rapidly between 1960 and 2005 by acquisition and opening new branches, and became the second largest in the UK after two of the largest had demutualised. With an ambitious CEO, it had expanded into commercial lending, and was on the trail for further growth when it was approached by the Co-operative Bank with the suggestion for a merger.
Co-operative Bank had been created as part of the Co-operative movement in 1872, and in recent years had similarly got the taste for growth under the umbrella holding company of Co-operative Financial Services (CFS) alongside Co-operative Insurance.
In 2008, the CEO of CFS met the CEO of Britannia to propose a merger, which would bring together the large branch network of Britannia and its newly updated systems, with the corporate bank, insurance services and ageing systems of the CFS Group.
The next few years turned into a nightmare, as the regulatory approvals were sought and systems integration (always a fraught business) proceeded. Matters were made more complicated, however, by a change of CEO at CFS and the decision of the CEO of Co-operative Group (which owned CFS) to integrate the management of CFS into the Group structure.
During this period of organisational integration, a bold decision was pushed through by the CEO of the Group to make a bid for over 600 branches of Lloyds Bank, which had recently ended up under Government control. This, however, would have involved a significant increase in capital, and the ex-Britannia CEO, now CEO of CFS, resigned in protest, he said, at the disruption this would cause in an already delicate merger transition.
The resulting focus on the underlying numbers indicated a £1.5bn shortfall in capital, soon followed by the realisation that there were £3.6bn of unrealised losses on the bank’s loan portfolio. It suggested amongst other things that Britannia’s foray into commercial lending had been much too risky (indeed, Andrew Bailey, Deputy Governor of the Bank of England at the time, expressed the view that without the merger, Britannia would have gone bust). Furthermore, the over-ambition of combining a major merger of organisations and systems with a plan to triple the branch network and integrate these new acquisitions into the Group, was clearly very ill-judged.
The disastrous bid to build a bigger presence in the UK banking market would have led the Bank of England to look at the governance structure outlined above and rapidly draw the conclusion that it could never comply with the standards expected of a large bank.
The bid was withdrawn, the bank appointed a new CEO from the senior ranks of HSBC, and the Group ended up selling its insurance business to raise capital, bringing in a hedge fund as a majority outside shareholder and eventually selling even its residual stake in the bank.
How were the members’ interests of these two mutuals looked after by the boards representing them? Britannia members became Co-operative Group members and survived the near-death experience, but hardly thanks to the management that took them through those torrid years. The chairman of Co-operative Group resigned after the bank posted a £700m loss in the first half of 2013, and the chairman of Co-operative Bank at the time and later of CFS also resigned and was subsequently banned from the financial services industry by the FCA following a conviction for possession of drugs and various other alleged misdeeds.
Not a great advertisement for the mutual model in terms of looking after members’ interests. Nowhere was there any sign of the existence of a strong risk management process to assess the potential impact of the Britannia merger, as a subsequent enquiry suggested that this was the primary cause of the subsequent problems. And finally, it illustrates the difficulties faced by a mutual when confronting a severe liquidity challenge.
3. John Lewis Partnership
John Lewis had worked as a draper in London, and in 1864 he set up his own business on Oxford Street. He was successful and dedicated and became a wealthy man. He brought his two sons into the business and one of them, Spedan, went on to succeed him when he died in 1928.
After gaining control, Spedan Lewis introduced his own ideas about management and ownership, and in 1929 he created a Deed of Settlement transferring shares in the new company, John Lewis Partnership, to trustees holding them on behalf of the employees, with profits being distributed to employees. In 1950 under a second Deed of Settlement, he transferred ownership of the company to trustees on behalf of the employees, and this constitution has remained in place to this day.
Employee interests are looked after by a Partnership Council whose members represent the views of subsidiary regional forums, three of whose members sit on the Board, and three of whom act as Trustees.
For many years, the John Lewis Partnership has been held up as an example of enlightened corporate governance, with an admired offering to customers and a happy set of employees, sharing in profits through annual bonuses and enjoying paternalistic employee benefits. In recent years, however, the Partnership has come under financial pressure as its business model has had to adjust to changing market conditions and increasingly severe competition. In January 2023 it announced losses of £234 million, up from a loss of £27 million in the previous year. It cancelled the bonus, for the second time in three years.
The chairwoman explained the need to cut costs and make funds available for needed investment in modernisation. However, comments have been made about the potential difficulties of dealing with a major refinancing in a couple of years’ time as loan repayments come due, against a recent history of poor trading performance. A story was leaked to the papers that the chairwoman was suggesting that up to £2 billion might be raised through bringing in outside shareholders, thereby breaking the 75 year old settlement. This was denied, but there was a very public adverse reaction to even the possibility in such a hallowed institution. The Financial Times estimated that to raise £2bn could involve selling as much as 25% of the equity.
In early May of this year, John Lewis partners had a meeting of their Council to vote on two resolutions: first avoiding voting to get rid of the CEO, but second voting to criticise the executive's performance. While it may influence their policy regarding partial de-mutualising, it won't help their financial position.
Currently, therefore, this mutual faces two fundamental problems:
To restore profitability, there will have to be staff cuts, not an obviously favourable move as far as employees are concerned, and;
It will be difficult to raise vitally needed funds both to roll over existing borrowings, but additionally to find funds for modernisation, without raising money through a share issue.
Neither of these essential steps fits very well with the constitution of this long-established mutual.
Current pressures on mutuals
Summing up the problems facing mutuals, illustrated by these three examples:
In long-established mutual organisations, there can be an issue with management inadequately experienced to cope with the pressures of a changing competitive environment; this was evident after the demutualisation of building societies, and, of course, after the privatisation of state enterprises, and the lack of adequate risk assessment in two of the examples above.
The rights of members may not be adequately safeguarded by the structures which have evolved over the years to represent their interests.
The restrictions on raising funding from the owners limits the mutuals to borrowing against the security of the assets of the organisation, which may be very dangerous if funds are required in large amounts or at short notice.
