DBRS downgrades Co-operative Bank to BB, Trend Negative

DBRS Ratings Limited (DBRS) has today downgraded the ratings of The Co-operative Bank plc (The Co-operative Bank or the Bank), including the Bank’s Long-Term debt and deposit ratings to BB from BBB (low), and the Short-Term debt and deposit ratings to R-4 from R-2 (middle). The Subordinated Bonds and the Perpetual Subordinated Bonds of the bank have been downgraded to Selective Default (SD) from CC, as DBRS views the liability management exercise (LME) as a Distressed Exchange, and will then be discontinued. The Intrinsic Assessment is now BB. The Trend on the long-term ratings is Negative.

The downgrade of the Long-Term debt and deposit ratings to BB reflects the magnitude of the required far-reaching restructuring of the Bank, which is larger than previously anticipated, and the still modest capital position of the Bank following the successfully completed LME. In addition, DBRS’s view that the Bank will remain susceptible to event risk while it undertakes the restructuring was a factor in the positioning of the long-term rating at BB. The Negative Trend reflects the execution risk inherent in the restructuring, as well as the potential impact on the franchise of the events of the last few months and the investigations into the activities and former management of the Bank and The Co-operative Group (The Co-operative Group or the Group).

DBRS views the recent completion of the LME as broadly positive for senior bondholders and depositors, as it enables the Bank to continue as a going concern and should provide it with time to carry out the restructuring. Following the LME, The Co-operative Group’s equity stake in the business will reduce to 30%, with the remaining 70% being owned by the former holders of the Bank’s lower tier 2 debt. The Bank is then to be listed in 2014. To reduce the impact of the increase in external ownership, the Group has incorporated its ethical approach into the Bank’s Articles of Association. DBRS expects that this will, to some extent, help to protect the Bank’s franchise from the potential adverse impact of the widespread media coverage of recent negative developments at the Bank and the change in the ownership structure. However DBRS views the announcement of several investigations into the Bank negatively as they have the potential to increase costs and take up management time, while the Bank is undertaking its significant restructuring.

The Bank’s large Non-Core division (Co-operative Asset Management or CoAm) comprises 44% of the Bank’s gross customer balances, but as a result of the higher risk profile of the assets, accounts for 62% of credit risk-weighted assets (based on Basel III final rules), as of end-June 2013. The over-arching aim of CoAm is to deleverage the balance sheet in a way that does not materially reduce the common equity tier 1 ratio of the Bank, especially as the restructuring of the Core business will mean that profitability is constrained, but in DBRS’s view this will be a substantial challenge. This reflects the significant downside risk in some of the loan portfolios within CoAm, such as the commercial real estate portfolio and the Optimum residential mortgage portfolio.

The turnaround of the Core business, which is now focused on retail and small business customers, will, in DBRS’s view, also be difficult, especially as a result of the widespread media coverage of the issues at the Bank and the change in the ownership structure. 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.

The current rating reflects DBRS’s concerns regarding the magnitude of the required restructuring of the Bank and the execution risk that the Bank faces as it reduces the cost base and re-engineers the IT infrastructure. The successful completion of the LME is expected to lead to the common equity tier 1 (CET1) ratio increasing to the upper end of a 7% - 9% range at end-2013. However the Bank expects the CET1 ratio to improve only modestly from this level in the coming years, as despite the further GBP 333 million to be injected by the Group in 2014, the likelihood of further provisioning charges and the restructuring costs mean that the Bank is unlikely to be profitable for some years. In DBRS’s view this evidences the relative lack of capital flexibility that the Bank has and highlights the challenge that the Bank faces to successfully restructure its operations while maintaining a capital buffer. Additionally DBRS notes that the Bank is not currently compliant with its Individual Capital Guidance (ICG) - the PRA’s statement as to the regulatory capital it expects the Bank to hold. The Bank does however expect to be compliant with its ICG at the end of the plan period.

Given the recent downgrade and the issues that the Bank continues to face, upward ratings migration is highly unlikely in the short to medium term. Downward pressure on the ratings would be likely if the core franchise of the Bank shows evidence of being further impaired, if further significant provisions are required, or if the Bank’s deleveraging of the CoAm business has a negative impact on capital ratios.

The downgrade to SD of the Subordinated Bonds and the Perpetual Subordinated Bonds reflects DBRS’ view that the LME is a Distressed Exchange. The terms of the exchange are disadvantageous to bondholders and the bondholders were compelled to consent to an exchange because failure to do so would potentially have led to the Bank being unable to continue to make legally scheduled payments as agreed. As the instruments will now cease to exist, following the completion of the LME, the SD rating will then be discontinued.

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 methodologies used include the DBRS Criteria – Intrinsic and Support Assessments and DBRS Criteria: Rating Bank Capital Securities – Subordinated, Hybrid, Preferred & Contingent Capital Securities. All can be found on the DBRS website under Methodologies.

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.

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/statistics/defaults.xhtml.

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: August 10, 2009
Most Recent Rating Update: November 14, 2013

For additional information on this rating, please refer to the linking document Located at:
http://www.dbrs.com/research/236983/banks-and-banking-organisations-linking-document.pdf

Information regarding DBRS ratings, including definitions, policies and methodologies are available on www.dbrs.com.