Will Nationwide be forced to become a bank?

Sorry to harp on about this dispute over how much and how fast Nationwide and Barclays need to raise capital to meet a new leverage ratio (see my recent blogs on this), but there is one implication I may have under-cooked.

Which is that it is very bad news for the future of mutual building societies.

The point is that Nationwide has important, totemic status among the mutuals, in that it is the biggest of them by far, and it battled through the great crash of 2007-08 relatively unscathed.

Which is one reason why many politicians and commentators posited that mutuality - ownership by customers rather than by conventional investors - might be the way forward for retail banking.

The recent financial woes of mutually owned Co-op Bank, and its forced decision to obtain a listing on the stock market, show that reports of a mutual revival were premature, to say the least.

And Mervyn King's last act as Bank of England governor, which was to encourage the unexpected decision of the Prudential Regulation Authority's board in favour of early introduction of a tough new leverage ratio, is another blow - perhaps a mortal one - to the mutual movement in finance.

Problems, problems

Imposition of a 3% leverage ratio, and the possibility that this could be increased at some point to 4% - which is what the Vickers Commission wanted - poses both a short-term and a long-term problem for Nationwide.

Before continuing, I need to explain what I mean by a leverage ratio, since not all of us talk about this financial arcana over breakfast (can't think why not).

This is the ratio between a bank or building society's capital, or the money set aside to absorb losses, the institution's shock absorber, and its gross lending.

As you may have heard many times before, the higher the leverage ratio, all other things being equal, the safer the bank - because said bank has more capital to protect savers from the impact of losses.

Now this is where it gets technical, tricky and tedious (the three "Ts" of banking regulation).

All banks also have to meet what is know as a capital adequacy ratio, set by the notorious Basel Committee, which is the ratio between loss-absorbing capital and loans weighted by risk.

As I am sure you know (you do, you do), loans made by the Nationwide and other building societies are primarily prime residential mortgages, which are seen by regulators as low risk.

So although Nationwide has £136bn of mortgages on its books, these have a "risk-weighted" value under the Basel rules of just £16.9bn.

All of Nationwide's loans and investments have a gross value of £190.7bn and a Basel risk-weighted value of £44bn.

So under the Basel methodology, as adjusted by the Bank of England's Prudential Regulation Authority, Nationwide is a sound bank if it holds capital equal to 7% of its £44.4bn of risk weighted assets - after allowing for possible future losses and other stresses (to use the hideous jargon).

The Nationwide passes that test with room to spare. It is sound, on the Basel view of things.

Belt and braces

However, if Nationwide's belt is holding up its trousers, its braces are too loose and threadbare: Nationwide has flunked the leverage test, because it doesn't have capital equivalent to 3% of its gross assets of £190.7bn, after provisions for those hypothetical stresses.

Or to put all this another way, the Nationwide's capital hole is due to the fact that its balance sheet consists largely of mortgages, which have a particularly low weighting under the Basel rules.

Now the Nationwide argues that the low weighting of its balance sheet is justified because its mortgages are very low risk, or so it argues.

Others, such as Mervyn King, would say that what looks like a low-risk loan today could become a hideous loss-maker, if interest rates were to rise sharply (which is not such a ludicrous idea, in the wake of the recent sharp rise in arguably the world's most important interest rate, ten-year loans to the US government, following the public musings of the US central bank the Federal Reserve about a possible end to the creation of cheap money next year).

Anyway, whatever the justice or not of the Prudential Regulation Authority's ruling that Nationwide has too little capital, the regulator is Judge Dredd for the Nationwide, the law, he who must be obeyed.

And since the regulator says Nationwide has a leverage ratio of just 2%, which is 1 percentage point less than the new minimum, Nationwide either has to obtain loss-absorbing capital equivalent to 1% of its gross loans, viz just under £2bn, or it has to somehow offload tens of billons of pounds of loans.

New capital

In an ideal world, the Nationwide would want to do a bit of both - shrink and raise new capital.

That said, the regulator's chief executive, Andrew Bailey, has said he won't accept any plan to meet the target which involves reducing the credit provided by Nationwide to households and businesses.

And although the Nationwide may be able to sell some of its assets to other financial institutions, it is safe to assume that it will have to raise well over £1bn in new capital and maybe as much as £2bn.

Which would be a pain and expensive for Nationwide even if it was a conventional bank with a stock-market listing.

But finding £2bn would be excruciating and perhaps prohibitively pricey for a mutual - since Nationwide can't sell normal shares to investors and will instead have to flog them bonds which behave like shares (by absorbing losses), funny paper which investors don't tend to like very much,

Here is the thing.

If Nationwide raises this capital by flogging this funny paper - and it is not clear that there is a deep enough market for this stuff - its costs will go up sharply, because it will be paying a high rate of interest on the funny paper.

And that in turn would impair its profitability, by putting up its costs, and probably forcing it to increase the cost of mortgages, which would reduce demand for its mortgages.


To put it another way, the rise in the leverage ratio makes it harder and more expensive for Nationwide to remain as a mutual.

All of which can be ameliorated a bit by the new governor of the Bank of England, Mark Carney.

He could, for example, put a bit of pressure on the regulator to set a deadline of the end of 2014 for imposing the new leverage ratio, rather than the end of 2013.

But all that would do is ease the short-term problem for the Nationwide.

It means Nationwide could raise perhaps a couple of hundred million pounds of the needed capital by retaining profits.

That said, it would still need to sell some of the expensive funny paper.

So almost whatever the date for meeting the leverage ratio, its mere existence puts pressure on Nationwide's board to abandon its cherished status as a mutual and become just another big bank listed on the stock market - because as a bank, its funding costs would probably be lower, and it would have greater flexibility in respect of the breadth of its activities.

Here is perhaps Mr Carney's first challenge: Can he help Nationwide to remain as a mutual, and thereby give hope to those who believe in mutuality?