Nationwide’s issuance of CCDS and solid interim results are credit positive

DBRS Ratings Limited (DBRS) commented today that the recent issuance by Nationwide Building Society (“Nationwide” or “the Society”) of GBP 550 million of Core Capital Deferred Shares (CCDS), together with the progress shown in the recently announced interim results, are viewed positively and underpin the AA (low) senior debt and deposit ratings. In DBRS’s view the issuance of the CCDS by Nationwide is positive for the Society in two ways: it improves the Society’s core equity tier 1 level, and it provides the Society with increased capital flexibility to either issue further CCDS or to issue contingent capital instruments that could revert to CCDS if required, in the future.

The CCDS is a deeply subordinated, perpetual capital instrument that is loss absorbing on a going concern basis. As a result CCDS meets the new regulatory definition of core equity tier 1. However to protect the mutual status of Nationwide the CCDS differ from ordinary equity in several ways. These include (i) that holders will have one vote at members meetings, in line with retail members; (ii) the maximum return is capped; and (iii) on a winding up of the Society the entitlement to a share of any surplus assets will also be capped. The ability of Nationwide to issue these instruments is a clear positive for the Society as, despite its mutual status, it provides access to core equity tier 1 capital other than through the retention of earnings. Previously building societies in the UK issued Permanent Interest Bearing Shares (PIBS) but these will not qualify as common equity tier 1 capital under the new regulations.

In DBRS’s view Nationwide already has a solid regulatory capital base as evidenced, at end-September, by a core tier 1 capital ratio of 14.2% and an estimated fully-loaded Basel III core equity tier 1 ratio of 11%. However, following the capital shortfall exercise carried out by the Prudential Regulatory Authority (PRA) earlier in 2013, under their definition, Nationwide’s leverage ratio was 2.1% at end-2012, below the 3% minimum required by the PRA. The plan announced by Nationwide in July 2013 to improve the leverage ratio to the 3% minimum by end-2015 did not include the issuance of CCDS, relying only on retained earnings. Therefore the GBP 550 million CCDS raised last week should help to speed up the process of reaching the required leverage ratio. DBRS estimates that, based on the assumption that the PRA adjustments are fixed, the PRA adjusted leverage ratio would have been approximately 0.25% higher at end-September if the CCDS were included, improving the leverage ratio to approximately 2.37%. However the still relatively low leverage ratio highlights the challenge that the Society faces to improve its profitability to reach the 3% requirement by end-2015.

DBRS also views the recently announced interim results of the Society positively, especially given the requirement to improve capital over the period to end-2015 to meet the leverage ratio requirement. In the period to end-September the Society reported a net profit of GBP 270 million, up 162% from the same period of 2012 reflecting an improvement in the net interest margin to 1.13% in the period, from 0.91% in the same period of 2012. As well as the impact of the Funding for Lending Scheme (FLS), notable drivers of the improvement in the net interest margin were the reduction in the cost of retail deposits, the re-pricing of existing assets and the increase in the number of mortgages reverting to the Society’s Standard Mortgage Rate rather than the lower Base Mortgage Rate. Impairment charges remain elevated driven by the further provisions being taken on the property finance book, however DBRS notes that although the commercial impairment charge was higher than the same period of 2012, at GBP 225 million it is GBP 75 million lower than the charge in the second half of 2012/13. Liquidity and funding remain solid and well-managed, underpinned by the substantial retail deposit base and the asset quality of the mortgage books remains consistently better than the industry average credit performance.

Nationwide’s AA (low) senior debt and deposit ratings also continue to reflect the strong domestic retail franchise, which is underpinned by its solid positions in residential mortgage lending and saving products, as well as its substantial high street presence. Additionally the society has been successful in further improving its franchise in recent years in current accounts where it now has an estimated market share of 6%. The trend on the ratings is negative reflecting a number of challenges facing the Society, in particular the need to improve its leverage ratio within a relatively short time period. Although the Society is primarily relying on retained earnings to reach the 3% required leverage ratio by end-2015, despite the recent improvements in the net interest margin, DBRS still considers the Society’s profitability to be constrained by some legacy issues including the high provisions on commercial real estate lending that have been required in recent years and the Society’s Base Mortgage Rate (BMR) promise to its members. As a result of these factors, and the Society’s mutual model that inherently generates lower levels of income, DBRS is of the opinion that the Society still faces a challenge to reach the leverage ratio requirement within the period to end-2015.

Notes:
All figures are in British Pound (GBP) unless otherwise noted.

[Amended on May the 23rd, 2014 to remove unnecessary disclosures.]