Credit Opinion: Co-Operative Bank PlcGlobal Credit Research - 24 Mar 2015
Manchester, United Kingdom
Category Moody's Rating
Outlook Rating(s) Under
Bank Deposits *Caa2/NP
Baseline Credit Assessment **ca Adjusted Baseline Credit
Senior Unsecured ***Caa2
Commercial Paper -Dom Curr NP
Other Short Term -Dom Curr (P)NP
* Rating(s) within this class was/were placed on review on March 17, 2015 ** Placed under review for possible upgrade on March 17, 2015
*** Placed under review for possible downgrade on March 17, 2015
Carlos Suarez Duarte/London 44.20.7772.5454 Michael Eberhardt, CFA/London
Johannes Wassenberg/London Maija Sankauskaite/London Key Indicators
Co-Operative Bank Plc (Consolidated Financials)
6-14 12-13 12-12 12-11 12-10 Avg.
Total Assets (GBP million) 41,076.6 43,396.1 49,772.8 48,955.6 45,581.3 -2.6
Total Assets (EUR million) 51,297.8 52,161.3 61,366.5 58,608.1 53,195.9 -0.9
Total Assets (USD million) 70,234.4 71,875.2 80,905.1 76,081.8 71,364.6 -0.4
Tangible Common Equity (GBP million) 1,988.5 1,632.2 1,444.6 2,108.4 1,968.2 0.3 Tangible Common Equity (EUR million) 2,483.3 1,961.9 1,781.1 2,524.2 2,297.0 2.0 Tangible Common Equity (USD million) 3,400.0 2,703.3 2,348.2 3,276.7 3,081.5 2.5
Problem Loans / Gross Loans (%) 11.0 10.8 11.0 8.1 7.8 9.7
Tangible Common Equity / Risk Weighted Assets (%) 14.3 11.7 8.1 10.4 10.1 14.3
Problem Loans / (Tangible Common Equity + Loan Loss Reserve) (%)
114.1 130.8 178.7 115.5 125.4 132.9
Net Interest Margin (%) 1.0 1.0 1.2 1.4 1.4 1.2
PPI / Average RWA (%) -1.2 -0.7 1.6 1.0 0.9 -1.2
Net Income / Tangible Assets (%) -0.3 -2.9 -0.7 0.1 0.1 -0.7
Cost / Income Ratio (%) 131.2 116.9 60.4 73.5 78.5 92.1
Market Funds / Tangible Banking Assets (%) 15.9 17.7 19.2 17.8 17.7 17.6
Liquid Banking Assets / Tangible Banking Assets (%) 26.1 22.6 25.0 26.4 19.8 24.0
Gross Loans / Total Deposits (%) 90.9 90.2 88.3 89.7 98.7 91.5
 All figures and ratios are adjusted using Moody's standard adjustments  Basel III - fully-loaded or transitional phase-in; IFRS  Basel II; IFRS  Compound Annual Growth Rate based on IFRS reporting periods  IFRS reporting periods have been used for average calculation  Basel III - fully-loaded or transitional phase-in & IFRS reporting periods have been used for average calculation
SUMMARY RATING RATIONALE
On March 17, we placed Co-operative Bank's long-term deposit rating of Caa2 on review for upgrade. We have placed the bank's BCA on review for upgrade following a number of successive capital increases. Conversely, we placed the Caa2 long-term senior unsecured on review for downgrade. The reviews on the ratings were triggered by introduction of the new methodology, and specifically our advanced Loss Given Failure (LGF) analysis as well as a review in our analysis on systemic support available for banks operating under operational resolution regimes. The Not-Prime short term debt rating and deposit ratings were all affirmed during the March rating action. Co-operative Bank's BCA at ca reflects (1) remaining challenges for the bank to become a sustainable and viable institution - via a business plan that involves significant execution risk in achieving its intended cost savings and business restructuring, (2) still vulnerable capital position and (3) significant differences in carrying value versus fair value for the non-core (Optimum) portfolio and potential additional conduct remediation costs, both of which may weigh on future profitability. However, we have placed the BCA on review for upgrade following a number of capital increases, which will likely lead to a one notch movement to caa3.
CO-OPERATIVE BANK'S BCA IS SUPPORTED BY ITS VERY STRONG- MACRO PROFILE
As a retail domestic bank, Co-operative Bank's operating environment is heavily influenced by the UK and its Macro Profile is thus aligned with that of the UK at Very Strong-. UK banks benefit from operating in a wealthy and developed country with a very high degree of economic, institutional and government financial strength as well as very low susceptibility to event risk. The main risks to the system stem from the high level of indebtedness of UK households, which are thus sensitive to changes in interest rates. UK banks are largely funded by deposits and banks' funding structure has remained relatively stable in the past few years, with slight increases in capital and internal funds as well as declines in short-term funding. The UK banking sector is relatively concentrated but the price-setting dominance of large banks is somewhat challenged by competition from the shadow banking market. RATING DRIVERS
- Relatively poor asset quality driven by large non-core portfolio - Capital levels benefiting from regulatory forbearance
- Profitability is negative and will likely remain low
- The bank's reliance on wholesale funding is low and current liquidity levels are sufficient RATING OUTLOOK
The review on Co-operative Bank's BCA was triggered by the introduction of our new methodology. Following the completion of a capital increase, a liability management exercise and the UK Prudential Regulation Authority's (PRA's) stress test, we decided to revise the stand alone ratings of the bank. The result will likely lead to an affirmation or an upgrade by one notch from its current level. In addition, we also introduced our advanced Loss Given Failure analysis, which applies to the bank given that it is subject to an operational resolution regime under the Bank Recovery and Resolution Directive (BRRD).
The review on Co-operative Bank's deposit rating will focus on the liability structure of the group, in particular the amount of senior long-term debt outstanding, and the amount of debt subordinated to it. However, we expect a one notch upgrade to this instrument class, if the BCA is upgraded, given that (1) it will likely benefit from a significant protection in the liability structure and thus face a very low level of loss-given-failure, and (2) we believe the probability of government support for holding company obligations to be low, resulting in no uplift.
expect this rating to get an affirmation, if the BCA is upgraded, given that (1) it will likely benefit from less protection in the liability structure and thus face a low level of loss-given-failure, and (2) we believe the probability of
government support for holding company obligations to be low, resulting in no uplift.
The outlook on the short term rating is stable since we do not expect that the net impact of our analysis will result in a rating change that could drive the current rating up.
What Could Change the Rating - Up
Upward pressure on the long-term debt and deposit ratings of the Co-operative Bank could develop over the longer term as we see evidence regarding the sustainability of the franchise; together with significant progress being made in the bank's restructuring, deleveraging and cost-saving initiatives. A positive change in the bank's BCA would likely affect all ratings.
What Could Change the Rating - Down
Negative pressure on the senior unsecured debt and deposit ratings would stem from either (1) the bank's inability to maintain its regulatory capital ratios at adequate levels, (2) delays in the progress on the cost saving and restructuring plans; or (3) a significant deterioration of its liquidity and, (4) higher than expected impairments or conduct related costs. A downward movement in Co-operative Bank's BCA would likely result in downgrades to all ratings.
DETAILED RATING CONSIDERATIONS
WEAK ASSET QUALITY, ALBEIT STABILISING DUE TO THE FAVORABLE OPERATING ENVIRONMENT AND THE ONGOING DELEVERAGING PROCESS
According to our calculations, the bank's problem loan ratio increased slightly to 11% as of June 2014 from 10.8% in 2013 with the non-core portfolio as the main source of problem loans. The non-core portfolio comprises the assets managed for run down or exit and includes the corporate, CRE and Optimum portfolios. The CRE and the corporate books are relatively concentrated and have high non-performing loan ratios of 63% and 45%,
respectively, although the coverage ratios of both portfolios is also high at 34% and 41%, respectively. Optimum, acquired as a result of the merger with Britannia was 14% impaired as of June 2014 (including those balances 30 days past due as per Co-operative Bank's definition) and continues to show significant differences between assets' carrying vale and their fair value amounting to around £1.1 billion.
Despite the slight deterioration in its problem loan ratio, the bank registered a significant decrease in impairment charges due to the deleveraging process and updating of collateral values. The bank registered a credit of £86 million in the first half of 2014 compared to a charge of £496 million at half year 2013. However, the bank's reported coverage ratio declined to 28.4% as of June 2014 from 33.5% at the end of 2013. We assign a Asset Risk score of caa2 to reflect these factors, which is lower than the assigned score we would assign using historical ratios to reflect the additional operational risk and high levels of sector and borrower concentration.
WEAK, ALBEIT IMPROVED, CAPITAL LEVELS AND OUTLINED BUSINESS PLAN INCORPORATES HIGH LEVEL OF EXECUTION RISK
Although the successful completion of the liability-management exercise (LME) in December 2013 and the additional £400 million capital increase in May 2014 comprised a significant milestone for Co-operative Bank's restructuring and resulted in an improved capital position, the bank still faces significant challenges to become a viable and sustainable institution given the high execution risk it faces in achieving targeted cost savings and restructuring of its operating model. In December 2014, the PRA released the results of its stress test for large UK banks and building societies, including Co-operative Bank. The bank was the only institution to fail the test, reporting a stressed capital ratio of -2.6%. As a result, the bank was required to submit a revised capital plan to accelerate the process to increase its capital and solvency levels.
The reduction of its non-core portfolio will likely take a long time given uncertainty regarding the pricing for assets in its portfolio although, we believe that the favourable operating environment in the UK will likely provide
opportunities for the bank to dispose of some assets in a capital accretive way. Nevertheless, we note the high levels of impairments and differences between the bank's assets' carrying value and their fair value, especially in relation to Optimum, a book of predominantly interest-only intermediary and acquired mortgage assets (reduced to £6.6 billion as of June 2014 from £7.1 billion a year earlier). Moreover, despite the improving operating conditions, there is also uncertainty regarding the turning point at which the bank will start to generate capital organically
through earnings retention. We note that the bank still requires some sizable investments in IT over the next three years (between £400 - 500 million).
Following the successful completion of the LME and the £400 million capital raise, Co-operative Bank reported a CRD IV fully loaded CET1 ratio of 11.5% as of June 2014, up from the 3% as of June 2013. The improvement in the capital position reflects the increase in CET1 of £1.1 billion and the reduction in RWAs by 3.6 billion year on year following the ongoing deleveraging. The bank's reported CRD IV fully loaded leverage ratio increased to 3.7% as of June 2014 from 1.1% a year earlier.
Despite this additional capital increase, we note that the bank will remain vulnerable to further shocks, and is reliant on regulatory forbearance, for a sustained period of time particularly relating to its non compliance with its Individual Capital Guidance (ICG). The bank has discussed, and agreed, a business plan with the PRA that would help to cure the ICG breach within 4 to 5 years. However, the PRA does retain discretion to revisit the Bank's non-compliance with its ICG. As a result, we believe that the bank has limited room to absorb unexpected losses, including conduct-remediation costs and additional impairments caused by adverse economic and market conditions. With the recent opening of various enforcement investigations by the PRA and FCA, the risk of fines being imposed against the firm remains significant. In addition, we believe that the bank may face some challenges to pass the PRA stress test given the severity of the losses that a sharp decline in house and commercial real estate (CRE) prices would imply plus the inability of the bank to offset these potential losses given its weak earnings generation capacity. We continue to believe that the bank's ability to generate meaningful additional capital and address any shortfall in the short term will rely heavily on its shareholders. We assign a Capital score of caa3 to reflect these factors.
PROFITABILITY REMAINS SUBDUED
We consider that the bank's profitability will likely remain negative for a number of years due to low interest margins, reduction of its non-core portfolio, potential further impairment charges, IT costs and potential conduct risks as well as an exceptionally high cost base.
Co-operative Bank reported a loss before taxes in the first half of 2014 of £76 million compared to a loss of £845 million at half year 2013. We note a material decrease in net interest income by 10% during the first half of 2014 compared to the same period in 2013 following the a reduction in the level of assets coupled with stable operating expenses. As a result, according to our calculations, the bank's cost income ratio increased to 131% as of June 2014 from 117% at end-2013. However, net losses declined significantly driven by lower impairment costs (£87 million credit compared to charges of £496 million) and a reduction in conduct remediation charges. We assign a Profitability score of caa1 to reflect these factors.
DEPENDENCE ON WHOLESALE FUNDING IS CURRENTLY LOW
The bank's funding profile remains a relative strength since customer deposits continue to be its primary source of funding (84% of total funding as of June 2014). The bank's reported loan-to-deposit ratio stood at 91% as of June 2014, (gross customer loans as a percentage of customer deposits). The bank has limited medium-term funding to replace in the next five years (about £2.9 billion). We assign a Funding Structure score of ba2 to reflect these improvements as well as the bank's lack of market access.
As of June 2014, the bank increased its liquid asset buffer to £7.6 billion from £6.98 billion at end-2013 on the back of a greater amount of balances with central banks. Since the bank maintains a sizable amount of liquid assets reflected in a Liquid Banking Assets/Tangible Banking Assets ratio of 22.6%, we assign a Liquid Resources score of baa2.
We also applied a negative qualitative adjustment reflecting expected lack of business diversification since Co-operative Bank has announced that going forward it will primarily focus on its retail franchise. We believe that on a forward looking basis, as the bank disposes of its corporate and commercial assets, its business model will be characterized by the following mono-line characteristics:
80% of revenues comes from a specific source (considering its expected trend); and 85% of the loan book is made of a single asset class.
We also apply a negative adjustment for Corporate Behavior. Although we believe that the current management team has developed a realistic de-risking and restructuring plan, the institution continues to face a number of
challenges given past control failures. As a result, the bank's future performance could still be affected by these legacy issues.
Overall our assigned BCA is ca. However, our scorecard indicated that the potential outcome range is between caa3 and caa1. Therefore, we have placed the BCA under review for upgrade with an expectation of up to one notch upgrade to caa3.
NOTCHING CONSIDERATIONS LOSS GIVEN FAILURE (LGF)
Co-operative Bank is subject to the UK implementation of the EU Bank Resolution and Recovery Directive (BRRD), which we consider to be an Operational Resolution Regime. We assume residual tangible common equity of 3% and losses post-failure of 8% of tangible banking assets, a 25% run-off in "junior" wholesale deposits, a 5% run-off in preferred deposits, and assign a 25% probability to deposits being preferred to senior unsecured debt. These are in line with our standard assumptions.
For Co-operative Bank's deposits, our initial LGF analysis is not conclusive and our review will consider the likely impact on loss-given-failure, due to the loss absorption provided by subordinated debt and, potentially, by senior unsecured debt should deposits be treated preferentially in a resolution, as well as the substantial volume of deposits themselves. Our preliminary analysis indicates a potential outcome of very low loss-given-failure, which would result in a Preliminary Rating Assessment (PRA) two notches above the BCA.
Our initial analysis for Co-operative Bank's senior unsecured debt is also not conclusive and therefore, our review will consider the likely impact on loss-given-failure of the combination of its own volume and the amount of debt subordinated to it. We expect this will result in a low loss-given-failure, which would result in a PRA one notch above the BCA.
The implementation of the BRRD has caused us to reconsider the potential for government support to benefit certain creditors. In the case of the Co-operative Bank, whose systemic importance has reduced, we now expect a low probability of support for deposits resulting in no uplift from the PRA.
Co-Operative Bank Plc
Weighted Macro Profile Very Strong -
Factor Historic Ratio Macro Adjusted
Credit Trend Assigned Score
Key driver #1 Key driver #2
Solvency Asset Risk Problem Loans / Gross
Loans 11.0% b1 ← → caa2 Sector concentration Quality of assets Capital
TCE / RWA 14.3% aa3 ↓ ↓ caa3 Stress capital
Profitability Net Income / Tangible
-1.0% caa1 ← → caa1 Return on
assets Earnings quality Combined Solvency Score ba1 caa2 Liquidity
Market Funds / Tangible Banking Assets
17.7% a2 ← → ba2 Market funding
Liquid Resources Liquid Banking Assets /
Tangible Banking Assets
22.6% baa1 ← → baa2 Quality of liquid assets Combined Liquidity Score a3 ba1 Financial Profile b3
Qualitative Adjustments Adjustment Business Diversification -1 Opacity and Complexity 0 Corporate Behavior -1 Total Qualitative Adjustments -2 Sovereign or Affiliate constraint Aa1 Scorecard Calculated BCA range caa1 - caa3
Assigned BCA ca Possible Upgrade Affiliate Support notching 0
Adjusted BCA ca Possible Upgrade
Instrument Class Loss Given Failure notching Additional notching Preliminary Rating Assessment Government Support notching Local Currency rating Foreign Currency rating
Deposits -- -- -- -- Caa2 RUR
Caa2 RUR Possible Upgrade Senior unsecured bank
debt -- -- -- -- Caa2 RUR Possible Downgrade Caa2 RUR Possible Downgrade
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