DBRS: Co-operative Bank remains Under Review following publication of the Recapitalisation Plan

DBRS Ratings Limited has today confirmed that the review, with negative implications, of the ratings of The Co-operative Bank plc (The Co-operative or the Bank) will continue until the results of the recently announced Recapitalisation Plan (the Plan) are known. This is expected before year-end. The ratings of the Bank were placed Under Review with Negative Implications on 20 June 2013 following the announcement by The Co-operative Group (Group) and the Bank, later confirmed by the Prudential Regulatory Authority (PRA), that the Bank requires an additional GBP 1.5 billion of equity capital.

DBRS views the substantially revised Plan, which includes an Exchange Offer to holders of the Bank’s subordinated debt and preference shares, as broadly positive for senior bondholders and depositors, because - assuming the Plan is successfully executed - it will enable the Bank to continue as a going concern and provide it with time to restructure. However DBRS considers that the magnitude of the required restructuring of the Bank combined with the execution risk that this entails are significant drivers of negative pressure on the senior ratings.

A successful Exchange Offer would result in the Group’s equity stake in the business being reduced to 30%, with the remaining 70% being owned by the holders of the Bank’s dated subordinated debt. The Bank is then to be listed in 2014. To try and reduce the impact of the increase in external ownership, the Group will incorporate the ethical approach followed by the Group into the Bank’s Articles of Association. DBRS expects that this will help to protect the Bank’s franchise from the potential adverse impact of the widespread media coverage of the issues at the Bank and the change in the ownership structure.

Additionally DBRS notes that the revised strategy of the new management team will focus on its retail and SME operations, but highlights the ongoing execution risk inherent in this multi-year and far reaching restructuring of the Bank. A further potential challenge will be managing the adjustment to being a listed company, as the new shareholders may have different strategic priorities from the Group’s priorities, particularly if the planned restructuring is not successful.

The Group and the Bank announced details of the revised Plan on November 4, 2013. In the Exchange Offer, the dated subordinated debt holders (totalling GBP 937 million) are offered a combination of equity, GBP 100 million in new tier 2 notes issued by the Bank, and the opportunity to subscribe for further equity in the Bank (up to GBP 125 million). DBRS understands that the GBP 125 million of new equity is underwritten by a group of investors in the Bank’s dated subordinated debt (although any holder of the Bank’s dated subordinated debt will be able to participate in this offering). Holders of the 5.5555% upper tier two notes (totalling GBP 200 million) will be offered up to GBP 106 million of new Bank tier 2 notes, also issued by the Bank. Holders of the 13% upper tier two notes (totalling GBP 110 million) and of the GBP 60 million tier 1 preference shares, who are primarily retail investors, are to be offered a choice between two different subordinated instruments, issued by the Group. However, both of these options will result in a substantial loss of value for these bondholders. The Exchange Offer is structured such that participation of all holders is required. Therefore, if a substantial majority (75%) vote in favour, then all securities will be incorporated in the Exchange. In the event that the Exchange Offer is not successful, then the Group believes that the alternative will be resolution of the Bank under the UK Banking Act 2009. This could lead to a multi-notch downgrade of the Bank’s senior ratings.

If the Exchange Offer is successful, then the Bank’s equity core Tier 1 ratio would increase substantially, with the Bank expecting this ratio to be at the upper end of a 7% - 9% range. The Group would then contribute GBP 373 million in 2014, dependent on a successful Exchange Offer, consisting of a cash injection of GBP 333 million and GBP 40 million in interest savings on the Bank’s securities.

The Bank has also provided the market with an update on its strategy and restructuring plans. Although the successful implementation of these plans should lead to a smaller, lower risk, bank, the magnitude of the required restructuring and the execution risk that this entails are significant drivers of negative pressure on the senior ratings. The split between the Core business and the Non-Core business has been redefined. Based on numbers at end-June 2013, the Non-Core division (to be called Co-operative Asset Management or CoAm) had GBP 14.2 billion of assets, and the Core business had GBP 30 billion. However, emphasising the higher risk profile of this division, at end-June 2013, CoAm accounted for 62% of credit risk weighted assets (based on Basel III final rules). As well as non-performing and defaulted loans, CoAm will also include assets that are no longer consistent with the core strategy, and those that cannot be supported by the retail platform of the Core business. As a result, many of the assets in the CoAm division are performing, including housing association and PFI lending. The over-arching aim of CoAm is to deleverage the balance sheet in a way that does not materially reduce the core equity tier 1 ratio of the Bank. However, DBRS highlights that the run-down of CoAm is expected to be a multi-year process, given the term of many of the assets, especially in the Optimum mortgage book and the housing associations lending book.

The Core business will be focused on retail and small business customers, with turnover of up to GBP 25 million per annum. Through a process of cost reductions (including the already announced 15% reduction in the branch network), a re-engineering of the IT platform, and re-pricing of products to market levels, the Bank aims for the Core business to have a low double digit return on equity over the 5 year planning horizon. A key challenge for the Bank will be to reduce its cost base, while maintaining its hitherto high levels of service that have differentiated it from many other banks in the UK market. As a result of this far-reaching restructuring, the Bank is unlikely to be profitable on a consolidated basis for several years. This, together with the substantial cost reductions and the re-engineering of the IT structure, highlights the execution risk that the Bank faces to successfully restructure its operations.

The dated subordinated debt and the Perpetual subordinated bonds, currently rated CC, remain Under Review with Negative Implications. As a result of the coercive nature of the proposed Exchange Offer and the substantial losses for bondholders DBRS expects to downgrade the securities discussed above to “D” at completion of the Exchange. The notching on these instruments is greater than the standard notching discussed in our published methodologies due to the high likelihood that substantial losses will be borne by the bondholders.

DBRS expects to conclude its review of the Bank’s ratings once the full results of the Exchange Offer are known. This is expected to be in the fourth quarter of 2013.

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 30, 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.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance

This rating is under review. Generally, the conditions that lead to the assignment of reviews are resolved within a 90 day period. DBRS reviews and ratings are under regular surveillance.

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Lead Analyst: Ross Abercromby
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 10 August 2009
Most Recent Rating Update: 20 June 2013

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