Mutuals under pressure to adapt or die

THE close relationship they enjoy with their members has been the proud boast of the building society movement for generations. But change is afoot in the cosy world of mutuals as the financial squeeze forces them to look at other means of staying afloat.

Last week, the Kent Reliance announced a pioneering link-up with a US private equity firm, which if followed by others could see control of savings and loans mutuals wrested from members and handed to City financiers.

The last couple of years have been brutal for the sector. Building society core business - mortgage lending - has collapsed by 92 per cent from 110 billion pre-credit crunch to 12bn, with savings crumbling to 23bn, a third of 2007's 77bn. Under the strain, ten substantial societies have thrown in the towel, with one, the Dunfermline, rescued by a deal sewn up between the government and Nationwide. The concern is that others could now come under threat as a row with the Financial Services Authority over the quality of building society capital reaches fever pitch.

Up to half of Scots rely on building societies for a home for their savings or to get a first step on the property ladder. Some like the Nationwide, Yorkshire, Skipton, Newcastle and Leeds have branches for customers to deal through, while others target Scots through their internet, telephone and postal campaigns. The UK's third biggest building society, the Coventry, for example, has few branches outside the English Midlands, and none north of the Border, yet looks after 22,500 Scottish members. Since the Dunfermline was taken over by Nationwide, the only home-grown societies are the much smaller Edinburgh-based Scottish and Century.

Building societies are different from banks in that they are owned by their customers, usually mortgage borrowers and savers, rather than shareholders. As such, they claim to be consumer-friendly organisations which eschew speculative activities and plough any profits back into cheaper loans and better savings returns for the benefit of their members.

When the credit crunch struck with a vengeance, the sector avoided the wholesale collapse witnessed by the banks, resulting in taxpayer rescues. Similarly, no building society savers have ever had to appeal for compensation from the Financial Services Compensation Scheme.

Only in the case of the Dunfermline was any taxpayer cash involved. When it collapsed, the Nationwide was handed 1.6bn to fill the black hole in the accounts of its branches, savings and prime mortgages. The Treasury retained the toxic commercial and other high-risk loan portfolios.

Despite the mergers, jobs in societies have been resilient compared with the tens of thousands lost at banks. Nationwide, which has also swallowed the Derbyshire and Cheshire, says 800 jobs have gone (75 at the Dunfermline) but 150 new ones have been created in Scotland.

All this has been achieved under interest-rate constraints never before witnessed. A prolonged period of the bank base rate at 0.5 per cent calls into question their very business model.

Societies require interest rates of around 3 per cent to pay staff and comfortably operate their branches and processing centres. A bank base rate of 0.5 per cent is too low to build in sufficient margin to cover costs.

Worse, some operated mortgage collar guarantees, on standard or tracker loans, which left them chasing down the base rate to crippling depths. They have also struggled with what they see as unfair competition from the state-funded banks. Finally, the FSA has gone to war over the quality of some societies' capital, causing headaches for, among others, Kent Reliance. Another difference between banks and building societies is the latter cannot raise cash on the money markets to develop their operations, relying largely on retained profits to expand.

As a concession in 1989, the old Buildings Societies Commission decided they could issue fixed-interest investments, known as Pibs, or permanent interest bearing shares.

This introduced a new class of largely institutional investor, who put long-term money into the society for a fixed reward without influence over the rights of little borrowers and savers. However, the FSA has decided that Pibs can no longer count as core, tier one capital, leaving those who hoped to rely on them in a big way in a hole. As one building society boss put it: "In this current market, if you had issued a good number of Pibs, and had some bad lending, you're toast."

The FSA has taken the view that Pibs are not recession-proof on the grounds that societies cannot cut the return to investors in tough times. It wants them to issue variable coupon stock, where the return can be reduced when storms break. This happened last year when the West Bromwich came close to hitting the skids. Its ability to meet a range of commitments, including its Pib interest, was under threat, so it converted 182.5 million debt into profit participating deferred shares, which were issued to institutions, with a promise of a 25 per cent share of the society's future profits.

The Kent Reliance had issued a large number of Pibs. Under the deal with JC Flowers, details of which should be announced later this week, a new holding company will be set up, which will own the society and of which members retain a controlling 51 per cent interest.

Nevertheless, they become customers of a bank, with 49 per cent of the profits going to a US private equity firm, rather than transforming into better pricing for customers.

Flowers, an unsuccessful bidder for Northern Rock, which has long wanted access to a UK banking licence, is seen as deal-driven. Observers expect the new entity to be floated in due course, breaking with mutual tradition.

Kent Reliance chief executive Mike Lazenby says: "I would have loved to have carried on as the building society has for the past 150 years, but I didn't think that was possible. We could either sit back and let the inevitable happen, as many societies have, or we could try to do something about it. It is better to have an organisation which is at least part-mutual than disappear altogether."

Other societies are far from convinced that external capital is the answer. There is also little appetite for the variable-rate instruments favoured by the Financial Services Authority.

Norwich & Peterborough chief executive Matthew Bullock, a former corporate banker, says: "The worry about variable rate coupons is that although these can be reduced in recession, in the good times the investors will want an ever bigger share of the profits. This will have an impact on the rates we offer members. As for external capital, how can you run an organisation along mutual lines if there are private equity bosses or other institutions calling the shots?"

Yorkshire Building Society chief executive Iain Cornish said: "In times of economic weakness, there has always been consolidation. It is important to remember the capital of merged societies is still held within building societies."

The government and regulators could take steps to give societies a chance. Building Societies Association director general Adrian Coles says: "We want the coalition government to commit to protecting diversity in financial services. It says it supports building societies, now we want action. We want less unfair competition from the state-owned banks such as Royal Bank of Scotland and Lloyds, and a review of the Financial Services Compensation Scheme, so that those who don't resort to it pay less."

But the capital issue is the most pressing. Skipton chief executive David Cutter agrees: "We need to reach a solution with the tripartite authorities and European regulators to ensure mutuals are able to access capital markets via an instrument defined as high-quality capital to allow them to compete with the banks and raise capital for a rights issue."