DBRS Downgrades The Co-operative Bank plc’s Senior Ratings to BBB (high), URN

DBRS Ratings Limited (DBRS) has today downgraded the ratings of The Co-operative Bank plc (The Co-operative or the Bank). The Bank’s Long-Term debt and deposit ratings have been downgraded to BBB (high), from A. The subordinated debt of the bank has been downgraded to BBB (low), from A (low), and the perpetual subordinated bonds have been downgraded to BB (high), from BBB (high). The Intrinsic Assessment for the bank is now BBB. DBRS maintains a SA2 Support Assessment and therefore the Bank’s Long-Term debt and deposit ratings continue to be positioned one notch above the Intrinsic Assessment. All of the ratings, including the R-1 (low) Short-Term rating, have been placed Under Review with Negative Implications.

The downgrade of the Bank reflects its weakening financial fundamentals, the slow speed at which Britannia is being integrated into the bank, the high level of management turnover, and the strategic challenges facing the bank as a result of the time spent pursuing the now aborted acquisition of Verde from Lloyds Banking Group.

The Bank’s financial fundamentals have weakened considerably in 2012, primarily as a result of the poor asset quality in the non-core corporate business. In 2012, the Bank reported a loss before tax of GBP 674 million, as a result of substantially higher impairment charges in the non-core book, as well as other one-off charges related to its IT infrastructure and redress for payment protection insurance (PPI) mis-selling. In addition to the higher impairment charges, profitability has also been pressured in recent periods as a result of the low interest rate environment, as well as the inability of the bank to fully integrate Britannia and therefore to benefit from the synergies that were expected at the time of the acquisition. As a result of the loss in 2012 the bank’s core tier 1 ratio has declined and at end-2012 stood at 8.8%, albeit this has increased on a pro-forma basis to 9.2% following management actions in January 2013. Under Basel III the Bank’s pro-forma capital ratio would have been 6.7% at end-2012, below the 7% level that the UK’s Financial Policy Committee has recommended that major UK banks should reach by end-2013. This highlights the need for the Co-operative to continue to improve its capital position. DBRS notes that the Co-operative Banking Group is in the process of selling its life assurance and asset management business, and that it recently announced that it will also sell its general insurance business. The proceeds from these sales will improve the Bank’s capital position, but DBRS notes that the disposal of the general insurance business may take longer than expected while there is no guarantee that it will occur.

At end-2012 the impaired loans as a percentage of gross loans ratio was 10.9%, up from 8.1% at end-2011. Although the Bank has taken increased impairment charges in 2012, coverage levels are still relatively low and therefore the bank is relying to a certain degree on the value of the collateral. Given the still challenging economic conditions in the UK, DBRS is concerned that collateral values may not recover sufficiently and therefore further impairment charges may need to be taken, particularly on the non-core commercial real estate loan book.

The rating action also reflects the management turnover at the Bank. Both the CEO and CFO of the Bank have recently left the bank and therefore a key challenge for the Bank will be to put in place a credible management team to deal with the issues that the Bank is currently facing. The Co-operative Group has also recently announced that it will not be proceeding with the planned acquisition of Verde from Lloyds Banking Group. In 2012 costs associated with this, now aborted, acquisition totalled GBP 38 million, further pressuring profitability. The acquisition would have provided a substantial boost to the breadth of the Bank’s franchise, as well as boosting the capital base and strengthening the management team, however the execution risks associated with integrating Verde into the Bank would have been very high, particularly given the poor track record on the Britannia integration.

DBRS notes that the Bank continues to have a strong funding and liquidity profile. At end-2012 the reported loan-to-deposit ratio was 92%, and the bank has very limited wholesale maturities in 2013 and 2014. The bank has a liquid asset portfolio of over GBP 7 billion and this is of high quality, primarily comprising central bank deposits and government debt. DBRS notes however that recent market events may constrain somewhat the Bank’s ability to access wholesale funding markets.

The downgrade of the Bank’s subordinated debt and the Perpetual subordinated bonds to BBB (low) and BB (high) respectively reflects the increased risk to these instruments as a result of the challenged capital position of the Bank. Although the Long-term debt and deposit ratings of the Bank continue to incorporate one notch of uplift for potential external support DBRS would not expect this to be forthcoming for more junior instruments and therefore, given the pressure on the capital position, the notching of these instruments from the senior rating has been widened.

In addition to today’s downgrade DBRS has also placed all of the ratings Under Review with Negative Implications. The review will focus on: the Bank’s plans to improve its capital position, including the potential sales of the insurance businesses; its ability to cope with further impairment charges and the likelihood of these being required; and the outcome of the Prudential Regulatory Authority’s review of the capital position and whether this has further implications for the Bank. Given the aborted Verde acquisition, DBRS will also review the Bank’s strategy going forward and the ability of the new management team to successfully execute on the strategy. In addition DBRS will also review whether the Bank's SA2 support assessment remains appropriate given the potential reduction of the Bank’s relevance within the UK banking industry.

Notes:
All figures in pound sterling (GBP) unless otherwise noted.

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organizations. Other applicable methodologies used include the DBRS Criteria – Intrinsic and Support Assessments and DBRS Criteria: Rating Bank Subordinated Debt and Hybrid Instruments with Discretionary Payments. These can be found at: http://www.dbrs.com/about/methodologies

[Amended on June 23, 2014, to reflect actual methodologies used.]

The sources of information used for this rating include company documents and SNL Financial. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Ratings assigned by DBRS Ratings Limited are subject to EU regulation only.

Lead Analyst: Ross Abercromby
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 10 August 2009
Most Recent Rating Update: 29 December 2011

For additional information on this rating, please refer to the linking document under Related Research.

For further information on DBRS’ historic default rates published by the European Securities and Markets Administration (“ESMA”) in a central repository see http://cerep.esma.europa.eu/cerep-web/