DBRS Downgrades Co-operative Bank to BB (low), Trend Negative

DBRS Ratings Limited (DBRS) has today downgraded the Long-term Debt and Deposits rating of The Co-operative Bank plc (the Bank) to BB (low) from BB. The Short-Term Debt and Deposits rating was confirmed at R-4. The Bank’s Intrinsic Assessment (IA) was also adjusted to BB (low) and the Support Assessment (SA) remains SA-3, meaning that the Bank’s ratings do not benefit from systemic support. As a result, the final rating for the Bank is the same as its IA. The trend on the Long-Term rating is Negative, while the trend on the Short-Term rating is Stable. As a result of today’s actions, the ratings have been removed from Under Review with Negative Implications, where they were placed on April 1, 2014.

The rating action reflects DBRS’s view that the Bank’s capital flexibility has declined after the recent completion of the Bank’s GBP 400 million additional Common Equity Tier 1 (CET1) raise. Although DBRS considers the completion of the raise as a credit positive, the fact that the need arose only five months after the earlier Liability Management Exercise (LME) leaves the Bank with little room for manoeuvre with regards to future capital generation, especially as DBRS expects the Bank to remain unprofitable for the medium term. In addition, DBRS notes that, although the Bank successfully completed the capital raise without participation of the Co-operative Group, there is also increased uncertainty regarding the future participation by the Group, as its equity stake in the business declined from 30% to 20% after the raise. The additional capital raise was necessary as a result of further charges relating to conduct and legal documentation that were not included when the Bank carried out its LME in December 2013. As a result of these issues, the Bank’s end-2013 CET1 ratio was 7.2%, substantially lower than the upper end of the 7 - 9% range that it had previously expected.

DBRS’s concern over the Bank’s capital flexibility is partially mitigated by the size of the recent capital raise, which improved its CET1 ratio to 9.8% on a pro-forma end-2013 basis. This is a key consideration in limiting the ratings downgrade to one notch. The Negative trend on the rating reflects both the execution risk inherent in the far-reaching restructuring, the Bank’s ongoing vulnerability to event risk, and the potential longer-term impact on the franchise of the events of the last few months, including the reduction in the proportion of the Bank that is now owned by the Co-operative Group.

Given the recent downgrade and the current issues faced by the Bank, upward ratings migration is highly unlikely in the short to medium term. Over the long-term, delivering improved earnings performance, successful de-leveraging of the Non-Core business without a meaningful impact on capital, and further strengthening of capital levels could have a positive impact on ratings. 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 Non-core business slows and has a negative impact on capital ratios.

In addition to the factors discussed above, the BB (low) rating reflects the magnitude of the required far-reaching restructuring of the Bank, and the susceptibility of the Bank to event risk, while it undertakes the restructuring. The Bank has made progress in deleveraging the balance sheet, with a GBP 2.1 billion reduction in Non-core assets in 2013. There remains, however, significant downside risk in certain Non-core portfolios, such as the commercial real estate portfolio and the Optimum residential mortgage portfolio. This risk is highlighted by the exceptionally high level of impaired assets and the significant divergence between the fair value and carrying value of certain assets, both of which could slow the deleveraging. Despite the significant headwinds in 2013, the Bank’s Core retail banking business reported a small operating profit of GBP 10 million for the year. Through a process of cost reductions (including the rationalisation of the branch network), a re-engineering of the IT platform, and the re-pricing of products to market levels, the Bank’s aim is for the Core business to generate a low double digit return on equity over the 5 year planning horizon.

Additionally, DBRS notes that the Bank is also reliant on regulatory forbearance. Currently the Bank does not meet its Individual Capital Guidance (ICG), the Prudential Regulatory Authority’s (PRA) statement as to the regulatory capital it expects the Bank to hold. Nor did the Bank meet the regulatory minimum leverage ratio of 3% at end-2013. DBRS does, however, note that following the completion of the additional capital raise, the Bank’s pro-forma end-2013 leverage ratio rose to 3.2%, from 2.4%.

Concurrently, DBRS has today withdrawn its legacy Long-Term Senior Debt rating on Britannia (formerly Britannia Building Society). This rating action is a consequence of the Bank’s assumption of the liabilities of Britannia when the two entities merged in 2009. The one outstanding Long-Term Senior Debt instrument, originally issued by Britannia, will now be listed under The Co-operative Bank, as it is now an obligation of the Bank.

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

The principal applicable methodology is the Global Methodology for Rating Banks and Banking Organisations. Other methodologies used include the following: DBRS Criteria: Support Assessment for Banks and Banking Organisations and DBRS Criteria: Rating Bank Capital Securities – Subordinated, Hybrid, Preferred & Contingent Capital Securities. These can be found at: http://www.dbrs.com/about/methodologies

The sources of information used for this rating include company reports 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 regulations only.

Lead Analyst: Ross Abercromby
Rating Committee Chair: Alan G. Reid
Initial Rating Date: August 10, 2009
Most Recent Rating Update: April 1, 2014

DBRS Ratings Limited
1 Minster Court, 10th Floor
Mincing Lane
London
EC3R 7AA
United Kingdom
Registered in England and Wales: No. 7139960

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.