The threat to Co-op’s plan to be a bigger bank

When Lloyds announced in December that it had chosen the Co-operative Group as its preferred bidder for more than 600 branches and £47bn of loans and investments, the government was delighted.

A senior government figure hailed the potential deal as a significant boost to competition and added that: "The projected combined current-account market share is around 7.6%, significantly above the threshold for a viable new challenger recommended by Vickers [the Independent Commission on Banking]."

The hope, of the Treasury under the Chancellor George Osborne, was that a significantly enlarged Co-op in banking would be good for consumers, by giving the UK's big banks a run for their money.

But here is the thing: The size of the takeover may well be its attraction, in respect of one aspect of public policy, but it looks likely to be its undoing, at the hands of another part of the state apparatus, the City regulator, the Financial Services Authority.

The FSA has told the Co-Op that if it goes ahead with the deal, there will be regulatory consequences that the Co-Op's management regards as onerous - heavy enough, probably, to kill the deal.

Because the Co-Op would become so large in the sensitive business of taking deposits, with care of tens of billions of pounds of savings for many millions of customers, it would be forced to change its corporate structure and governance, and dedicate more capital to banking, to protect depositors from losses.

According to sources close to these sensitive negotiations with the FSA and with Lloyds, there would be a number of important implications:

  1. The Co-Op Group as a whole would be categorised by the FSA as a financial institution, as opposed to the general conglomerate it is today;
  2. It would therefore have to put in place new formal arrangements giving explicit priority to its banking operation in the allocation of management and financial resources;
  3. There would have to be a significant shift in power within the group, from the democratically-elected group board to bankers and financial experts, and the group chief executive would have to be a banker (which the incumbent, Peter Marks, is not);
  4. Because of the imperative of maintaining high levels of capital in the banking part of the Co-Op, the group's ability to invest in its important supermarkets and other services could be restricted.

Or to put it another way, the proposed takeover of the Lloyds operation - which is called Verde - is forcing the Co-Op to re-evaluate its future in a fundamental way. There is a challenge to its culture.

And, according to my sources, the FSA is broadly saying to the Co-Op that it has to decide whether its future is in banking or in supermarkets (although I am sure the FSA would deny putting it in such stark terms).

So a decision for the Co-op about getting bigger in banking has become about something altogether bigger. Which is why Lloyds - which has to sell Verde by the end of next year - is still hoping the deal will happen, but rather assuming it won't.

The Co-op has till the end of June, which is when its exclusive right to negotiate with Lloyds expires, to make up its mind - although a decision is likely much sooner.

Right now the likelihood is that Lloyds will eventually opt to float Verde on the stock market - although there is a small possibility that it will revive talks on selling it to NBNK, the company specially created to buy banks by Lord Levene.

Does any of this matter?

Well, first it is a bit odd that the Co-Op and Lloyds were not apparently aware of the magnitude of the regulatory hurdle on December 14, when they went into their exclusive preparations for the nuptials. There are mutterings from them that the FSA was slow off the mark in expressing its reservations.

Which points to the more important issue.

We have a government that is determined to stimulate and promote competition in retail banking, and which also wants to encourage mutuals like the Co-op. These are rare policies, in that they enjoy enthusiastic support from Labour and the opposition parties

So it will be galling to MPs and ministers that the proposed creation of a bigger Co-op Bank - which was seen as posing a far bigger competitive threat to RBS, Barclays, HSBC and Lloyds than the alternatives and might have sparked something of a mutuals revival - is likely to be sacrificed at the altar of protecting depositors and maintaining financial stability.

Some will argue that the FSA is now placing excessive restrictions on banks, having - by its own admission - failed to curb their recklessness in the boom years before 2007-8.

But there is an economic tragedy here, that it has become even harder to reconcile the twin imperatives of keeping banks safe while challenging their perceived oligopolistic complacency.