Mutual capital in the UK and beyond

1. Mutual capital in the UK and beyond Mutuals’ Forum ’10 4 November 2010 Jeremy Palmer Head of Financial Policy, BSA

2. Introduction • Overview of BSA’s UK experience in fighting for recognition of mutual capital instruments • Detail relates to banking regulation, but the high-level issues are more general • Similar problems may surface for mutual insurers • Illustrates fundamental issues of principle • Mutual and cooperative model differs from the proprietary capitalist model • Later speakers will cover situation in Germany, and rest of Europe

3. How do mutuals /cooperatives differ from PLCs ? They give a different answer to two basic questions… For whose benefit is the entity in business ? Who benefits from the entity’s surplus ? In a PLC, the answer to both is : the shareholder who provides equity capital In a mutual or cooperative, the answer to both is : the customer-member Back to basics…..

4. The Co-operative economic system has broken with the practice of ordinary profit-seeking enterprise, not only through its rules of association and democratic administration, already discussed, but also through the rules which determine the allocation and division of savings and other financial benefits successful co-operatives yield to their members. This has its origin notably in the resentment with which many working people regarded the distribution of property and income in 19th century society, because in their eyes it was both unequal and unjust. While the immediate goal of co-operative effort among them might be to cheapen the necessaries of life for consumers or to provide a decent living for producers, the ultimate aim was to establish a new social order characterised by what they called `Equity' in the distribution of wealth and income. The new industrial techniques, then as today, had an insatiable appetite for capital. People who possessed or commanded money for investment wielded a bargaining power which enabled them to obtain, at the expense of the other factors of production, high dividends and an accretion of capital values representing something much more than interest - the lion's share of the profits of industry as well. Extract from Report of the ICA Commission on Co-operative Principles (1966) Some history…..

5. The banking crisis consumed a lot of deposit-takers’ capital…. ….and revealed that starting levels were too low. So a major plank of “regulatory repair” is… …to require higher levels, and higher “quality” of capital But what does high “quality” really mean ? Capital for mutuals – Why such a problem now ?

6. Capital mitigates and absorbs risks inherent in banking esp. credit intermediation… ..and protects depositors by assuring a bank’s resilience Capital not the sole mitigant, nor the answer to everything…..….but still very important Mutuals and cooperatives agree that capital is very important….. ….…which is why we retain surplus to build reserves instead of over-distributing dividends or bonuses like the PLC banks What is Capital for ?

7. Capital = Reserves plus risk-bearing instruments In a simple company = reserves plus ordinary shares (“core tier 1”) But ordinary equity may be expensive or unavailable…. ….so supplementary capital – prefs, hybrids and sub. debt widely used in banking But these exotic hybrids proved not much use – in the crisis….. …so banks now made to hold much more core tier 1 What counts as Capital ?

8. Basel fetishises the PLC ordinary share Based on the “basic ownership” concept which only works in the capitalist model Let’s go back to the two basic questions….. Basel in effect says mutuals/coops can only issue core tier 1 if the capital providers get all the benefits of the enterprise To apply this to mutuals at all is a category error Why the ordinary share can’t work for mutuals

9. No wonder the IMF (itself a cooperative) said…. We note that the eligibility criteria for Core Tier 1 capital [outlined in Annex IV] are fundamentally inconsistent with the nature of member shares in cooperative banks (notably,criteria 2, 3, 5, and 8). ……Not all of these criteria are essential to assuring the loss absorption capacity of capital, and most cooperatives have large accumulated reserves that provide a sound buffer against losses. The Basel error

10. Building societies’ capital is mainly reserves First new instrument – PIBS – introduced in 1991 “Core tier 1” now requires stronger loss-absorption features So we need another instrument – PLADS Principal Loss Absorbing Deferred Shares But no compromise on fundamentals – mutuals’ business is run for their members, not to extract profit for capital providers The principle is : “limited interest on capital” So PLADS have a limit on distributions So what do mutuals use for capital ?

11. No, we didn’t make them up just to be awkward Developed from the insights of the Rochdale Pioneers Reviewed and updated by the ICA from 1937 Relevant to our argument are Rochdale Principles 3 and 4 Address how the customer-members share in the cooperative’s surplus, and what return the capital provider is entitled to Where do these principles come from ?

12. The Committee are of opinion that there should be some discrimination in the importance to be attached to these seven points in deciding the essential co-operative character of any Society or organisation. They suggest that the observance of co-operative principles depends on the adoption and practice of the first four of the seven Principles, viz., Open Membership Democratic Control (O M O V) Distribution of the surplus to the members in proportion to their transactions Limited Interest on Capital. …….from the 1937 ICA report

13. In the old-established Co-operative Movements, with their powerful central institutions for trade, banking and insurance, the rule of self-finance must receive, under contemporary conditions, a broader formulation. Self-financing tends to become ever harder and may end by becoming impossible for primary societies. The time may even come when, under the stress of competition and the urgent need to extend their structures and renew their equipment, the national movements will be unable to finance their operations without attracting capital from outside. Cases may even occur when the necessity of competing successfully for the favour of people with savings to invest against savings banks and the securities dealt in on the stock exchanges may tend to restrict the freedom of co-operative organisations to fix their interest rates according to their own principles.All the more reason, therefore, why Co-operators should clearly understand what their own principles require in this connection. Limited interest on capital The ICA looked ahead in 1966

14. PLADS will be permanent deferred shares repayable only on a winding up PLADS will have discretionary distributions, not a contractual coupon, to ensure flexibility PLADS will have a shadow reserve ledger to demonstrate loss absorbency Distributions will be capped at a stated percentage to prevent alienation of surplus from the members So how will PLADS work ?

15. PLADS could be held by institutions, high-yield funds or retail investors Will need listing and secondary market Designed to provide a fair, stable return for the risk taken– like an income or utility stock COB issues for sale into retail market PLADS probably suit high net worth end, like PIBS Could be v important for smaller societies Similar instrument – CCQS –designed for CFS / Cooperative Bank So how will PLADS work ?

16. BSA continues advocacy in Europe as well as UK European authorities recognise the mutual / cooperative issue on core capital MEPs sympathetic and active Need to get this confirmed in Directive text More work with institutional investors More work on retail COB issues More work on secondary market What’s next…..

17. Mutual capital in the UK and beyond Mutuals’ Forum ’10 4 November 2010 Jeremy Palmer Head of Financial Policy, BSA