Treasury Committee publishes Project Verde Report

• Inquiry page: Project Verde
• Publications: Project Verde Report

Some of the key conclusions and recommendations contained in the report include:

A full list of the conclusions and recommendations can be found on pages 104-116.

Collapse of Co-op Bank’s bid for banking competition

One of the most significant consequences of Co-op Bank’s near-collapse, from a public policy perspective, was the collapse of Lloyds Banking Group’s planned divestment. Co-op Bank’s withdrawal forced Lloyds to resort to its fallback option of an Initial Public Offering. The result is a new bank—TSB—which, not having an existing banking presence of its own, consists solely of the business divested by Lloyds. Accordingly, it has a personal current account market share not of 7 per cent, but of 4.2 per cent. There is a risk that a bank of this size might struggle to grow significantly and to act as a true challenger in the market. This is not a judgement on TSB or its management, but reflects an observation of the Independent Commission on Banking that the entity resulting from Verde should have a market share of at least 6 per cent to have the best chance of becoming an effective challenger bank. (paragraph 300)

There is reason to think that the frailty of Co-op Bank’s capital position could have been discovered sooner—specifically, if the bank had monitored its loan book and its treatment of customers more effectively, and if it had accounted for its banking IT programme in a different way. Had Co-op Bank’s resulting capital shortfall been uncovered earlier, it is likely that the bank would not have progressed so far with Verde. As it was, the rapid and late emergence of the capital problem led to Co-op’s withdrawal from the Verde process at a relatively late stage. The Committee recommends in paragraphs 127, 128 and 155 that the FRC investigation and the independent inquiry into the events at Co-op Bank consider the role of KPMG and the FSA in relation to the late emergence of loan impairment and IT losses. On the basis of these findings, the independent inquiry into the events at Co-op Bank should also form a view on whether Co-op’s Verde bid could or should have been halted sooner. (paragraph 168)

Chairman's comments

“The Verde divestment should have been an opportunity to establish a significant new challenger in the UK retail banking market. But the opportunity was scuppered by the discovery, at an advanced stage in the process, of Co-op Bank’s capital shortfall by the bank, KPMG and the regulator. Lloyds has subsequently resorted to its fallback plan of an IPO. The resulting new institution will have a smaller market share than may be needed to make a success of a challenger bank. If this turned out to be the case, it would be a setback for competition in the UK banking sector.

“It is not uncommon for deals to collapse. But in this case it was caused by the near collapse of Co-op Bank itself. Each of the backstops—Co-op Bank itself, KPMG as its auditor, and the FSA as its regulator—failed to uncover the bank’s capital shortfall until it was too late. Each had a hand in this sorry tale. But by far the biggest responsibility lies with the Co-op Bank leadership.”

Was the bidding process fair?

Lord Levene made a number of serious and specific allegations to this Committee. He alleged that there was political interference to the public detriment in the Verde deal, and that this constituted bad faith. He alleged that Lloyds moved the goalposts of the Verde auction to help ensure that Co-op won, and that this also constituted bad faith. Lord Levene further asserted that it was not reasonable for Lloyds to have concluded that Co-op Bank’s bid was superior to NBNK’s on commercial grounds. (paragraph 271)

The Committee concluded that the allegation of political interference was of sufficient concern to require oral testimony from the Chancellor. He assured us that the Government brought no undue pressure to bear on the Verde process. The Committee also heard from António Horta-Osório and Sir Win Bischoff that the Government applied no pressure to Lloyds in respect of the Verde deal. Andrew Bailey told the Committee that the Government had not put the regulator under any pressure in respect of its primary obligations. Peter Marks told the Committee that he was not aware of any pressure being placed on Co-op by the Government to bid for Verde. Robin Budenberg told us that UKFI had not advised Lloyds of any preference for Co-op Bank’s bid. Sir Nicholas Macpherson said that he was not aware of any improper behaviour by politicians with respect to the Verde transaction, and that he would have expected such behaviour to have been brought to his attention. (paragraph 272)

Lord Levene’s central allegation is of political interference in the Verde process, to the public detriment. The Committee heard strong and unambiguous denials from those involved—Lloyds, the regulator, Co-op and the Treasury. It is difficult to think of an explanation that would sustain Lord Levene’s allegation, other than that all our witnesses had either suffered a failure of memory or intentionally misled the Committee. The latter explanation would also require witnesses to have similarly misled Sir Christopher Kelly, who found no compelling evidence of political pressure for Verde to go ahead. Furthermore, for their credibility to be maintained, it would presumably require witnesses to have taken a decision to sustain their mendacity during the forthcoming independent inquiry into the events at Co-op Bank. It would also have required the board members of Lloyds Banking Group to have neglected their fiduciary duty to shareholders—by selecting a bidder which, if Lord Levene’s allegation is to be believed, was manifestly unsuitable in commercial terms—at huge reputational, professional and personal risk and for no apparent benefit. And it is likely also to have required the chief legal counsels of Lloyds, the Treasury and the regulator to have countenanced Lloyds’s proceeding with an inferior bid on the basis of political expediency. The Committee does not consider all this to be plausible. Nor does it consider it likely that such serious and far-reaching impropriety and bad faith as Lord Levene alleges could have been covered up in several major public and private bodies for over two years following the conclusion of the bidding process. (paragraph 273)

In his oral evidence to the Committee, Paul Flowers agreed with other witnesses that there had been no political pressure in the Verde process. In response to six further separate questions from the Committee, he confirmed this view. In a subsequent press interview, however, he contradicted this evidence, claiming that Co-op Bank had come under "considerable" pressure from the Government during the bidding process. Given the flatly contradictory nature of his evidence, the Committee does not consider Mr Flowers a reliable witness—on Verde, on the Britannia deal, or on any other matter—and has not taken his evidence into account in any of its conclusions. (paragraph 274)

The only relevant evidence that the Committee has heard claiming that there was political interference in the Verde deal has come from Lord Levene. In turn, Lord Levene admitted that the only “hard evidence” he had of political interference came from a conversation with the former Governor of the Bank of England, Lord King, in which Lord King had informed him that Lloyds’s Verde decision would be made on political grounds. Lord Levene told the Committee that the Governor had called for this meeting, creating the impression that there was something that the Governor particularly wanted to communicate to Lord Levene. The Committee has investigated these allegations. Lord King has told the Committee, however, that he did not instigate the meeting. Furthermore, Lord King told the Committee that the concerns he expressed in the meeting related only to delays in the divestment process, and not to political involvement in Lloyds’s decision. Lord King’s recollection of the meeting is supported by a contemporaneous note of the meeting produced by a Bank of England official. Lord Levene continues to dispute Lord King’s position, but on the basis of the evidence that it has taken, the Committee is inclined to accept Lord King’s version of events. (paragraph 275)

The Chancellor agreed that the Government was pleased to see Lloyds proceed with Co-op’s Verde bid. This was consistent with the Government’s stated policy both to encourage mutual firms and to deliver a challenger bank of the size proposed by the Independent Commission on Banking. Witnesses from Co-op Bank claimed that the Government had expressed its "goodwill" towards the bank’s bid. Lloyds agreed that it was “publicly well known” that the Government looked favourably on Co-op’s bid—a preference made clear to Lloyds once it had first named Co-op as preferred bidder in December 2011. The regulator was also aware of the Government’s support for Co-op Bank’s bid. The Committee has seen no evidence, however, that the goodwill expressed by the Government towards Co-op Bank’s bid amounted to pressure on any party. Our witnesses have presented us with overwhelming evidence to the contrary, and the Committee therefore rejects Lord Levene’s allegation of political interference in the Verde deal. (paragraph 276)

The Committee has considered Lord Levene’s allegation that Lloyds ‘moved the goalposts’ of the Verde process to ensure a Co-op victory. While Lloyds did change the bidding process on a number of occasions, it was reasonable for it to have done so. The changes that were made appear to have been in the interests of Lloyds’s shareholders, and to have benefited on different occasions both Co-op Bank and NBNK. Lloyds also changed the package of assets on offer, but this was in response to requests from both bidders, and was advantageous to both. The Committee therefore rejects Lord Levene’s allegation. (paragraph 278)

The Committee has also considered Lord Levene’s allegation that Co-op Bank’s Verde bid could not reasonably have been judged superior to NBNK’s. Comparison of the Co-op Bank and NBNK bids was clearly a complicated and technical matter. Lloyds had to weigh up a number of competing factors in coming to its decision. Its view of the financial merits of both bids was based on independent professional advice. It knew that there were execution risks with both bids—the regulator had made this clear—and, while Co-op Bank eventually withdrew from the process following the revelation of the capital shortfall, this was not reasonably foreseeable at the time of Lloyds’s decision. On the basis of the evidence it has taken, the Committee rejects Lord Levene’s allegation that Lloyds was unreasonable in judging Co-op Bank’s bid to be superior on commercial grounds at the time of the Verde bidding process. (paragraph 279)

Lord Levene himself accepted that political interference might not have been the explanation for Co-op’s Verde victory. He told the Committee that a desire from Lloyds to divest Verde through an Initial Public Offering, and to secure this outcome by awarding Verde to a Co-op bid that was likely to collapse, was “probably the real answer”. The Committee does not endorse this view of events. But the Committee notes that Lord Levene, the only voice alleging specific improper political involvement in Verde, has concluded that a sufficient explanation for the outcome of the bidding process could reasonably be provided by Lloyds’s own commercial objectives. (paragraph 280)

Chairman's comments

“Lord Levene made a serious allegation of political interference in the Verde bidding process. The Committee has seen scarcely any evidence in support of this claim. The allegation was rejected by every other witness who appeared before the Committee. The decision by Lloyds to select Co-op’s bid over NBNK’s is explicable on straightforward commercial grounds.

“In any case, it seems improbable that any such political interference could have been concealed by so many people and for so long. The Government publicly stat  ed its support for Co-op’s bid, but the Committee has not seen anything to suggest that this constituted improper pressure or bad faith on anyone’s part.

“Co-op Bank’s bid carried risks. But so did NBNK’s. The Committee has not seen evidence that anything other than Lloyds’s commercial objectives determined its decision.”

Governance

Co-op Bank’s governance structure up to the middle of 2013 was entirely inadequate for a bank of any size; it is shocking that it was in place in an institution that came so close to becoming a major new challenger bank. Co-op Bank’s board was dominated by members from the parent group who lacked financial services experience. Those members with financial services experience were responsible for overseeing a very broad range of business. Being small in number, their expertise was spread too thinly, and ran the risk of being over-ruled by possibly well-meaning, but inexperienced, democratic members of the board. Yet, at least from 2009 to 2011, the board was also too large and unwieldy to allow for meaningful discussion and debate. The executive was also subject to influence from Co-op Group, with the bank’s Chief Executive in a direct reporting line to the group’s Chief Executive from 2011. (paragraph 203)

The deficient composition of Co-op Bank’s governance was embodied in Paul Flowers, who lacked any of the requisite financial services experience to act as Chairman of a bank. In this regard he appointed two experienced Deputy Chairmen to strengthen the advice to him and the board. Mr Flowers was appointed on the basis that he would be able to navigate the ‘politics’ of Co-op Group and chair the board. We took evidence that he had performed these functions well. But this was an inappropriate basis for his appointment. An effective bank Chairman should possess a good deal of experience of financial services. He or she should be at least capable of understanding financial issues. Mr Flowers lacked both the desirable experience and the minimum essential skills. He should not have put himself forward for the role. Co-op should not have selected him. The regulator should not have permitted his appointment. (paragraph 205)

Clive Adamson and Andrew Bailey have said that an individual with as little financial experience as Mr Flowers would not be appointed as Chairman of a bank today. That he was allowed to perform the role at all is further proof, if it were needed, of the inadequacy of the Approved Persons Regime. This regime, in principle the means by which the regulator can ensure that those who run banks have the requisite expertise, is in practice a narrow box-ticking exercise. It operates mostly as an initial gateway, providing very little subsequent oversight of those at the most senior levels in banks. The new Senior Managers Regime—recommended by the Parliamentary Commission on Banking Standards, given statutory underpinning by the Government and now being consulted on by the regulators—seeks to address these deficiencies. Properly implemented, the regime provides a better prospect that the most senior individuals will have sufficient financial expertise to perform their roles effectively, or at least have the capacity to understand the questions put before them and to ask some of their own. (paragraph 206)

While the Approved Persons Regime will be abolished for the banking industry, it will be retained for many in the remainder of the financial services industry, including insurance and asset management. Given its manifest failings, this appears hard to justify. Clive Adamson, Director of Supervision at the FCA, appeared in oral evidence to agree with this view. The Government and the regulators should at the earliest opportunity make proposals to extend the coverage of the Senior Managers and Certification Regimes to, and remove the application of the Approved Persons Regime from, other parts of the financial services industry. (paragraph 207)

Chairman's comments

“The structure and composition of Co-op Bank’s board was an accident waiting to happen and badly let down Co-op members and customers. Co-op Bank’s governance structure was not fit for purpose for any bank, let alone one bidding to become a major challenger in the UK market.

“The failings of Co-op Bank’s board are, among other things, an indictment of the discredited Approved Persons Regime. The new, much more narrowly drawn, Senior Managers Regime, if implemented properly, offers the prospect that the Approved Persons Regime’s shortcomings can be rectified. This is a work in progress.

“The Approved Persons Regime remains in place for the majority of financial services firms, despite its manifest failings. This is a mistake, and one which must be addressed soon by the Government and regulators.”

Bidding for Verde

From the start of the Verde process in 2011, the FSA was sceptical of Co-op Bank’s ability to take the transformational step represented by the acquisition of the Verde branches. The FSA’s concerns spanned almost every material aspect of Co-op Bank’s business: its liquidity and risk management framework; its integration strategy; its governance framework; its senior executive management team; and its capital plan. Co-op Bank took steps to address some of these concerns. But the FSA remained unsatisfied on a number of points, and even after Co-op Bank signed Heads of Terms in July 2012, the regulator expressed disquiet about Co-op’s governance, its integration plan, and its prospective financial soundness. (paragraph 77)

Neville Richardson, the bank’s former Chief Executive, warned at the start of the process in mid-2011 of the management burden that the Verde transaction could pose. Co-op Bank’s Deputy Chairmen had doubts about the commercial sense of the transaction: whether Co-op possessed the necessary resources and competence to compete in banking as well as other markets, and whether the economic outlook and future regulatory capital pressures might make the deal less attractive. Following a significant costing error in the bank’s IT replacement programme, both Deputy Chairmen also began to doubt whether Co-op Bank was even capable of completing the integration with Verde. (paragraph 78)

However, it was not clear at the time that the numerous and varied challenges facing Co-op Bank’s bid were insurmountable. Despite knowing the FSA’s views on the difficulties that Co-op faced, Lloyds chose to pursue a deal with Co-op Bank, both in the December 2011 and the June 2012 rounds of bidding. Co-op Bank’s Deputy Chairmen, though they had doubts about the transaction, did not recommend to the regulator in their exit interviews that the deal be stopped. Neville Richardson similarly wanted Verde to go ahead, with the proviso—made clear in the script of his conversation with Peter Marks and others in July 2011—that other projects should be implemented more slowly. Notwithstanding its own deep misgivings, the FSA did not instruct Co-op to call off its pursuit of Verde. Instead, it afforded the bank the opportunity to address its concerns. (paragraph 79)

By setting out strict conditions that Co-op Bank would need to meet for the deal to go ahead, the FSA permitted Co-op Bank to take its own commercial decision without the regulator’s statutory objectives for financial stability and consumer protection being put at risk. While there remained any reasonable prospect that Co-op Bank might be able to meet these conditions, it was appropriate for the FSA to allow the deal to progress. (paragraph 80)

The financial collapse of the Co-operative Bank

The collapse in Co-op Bank’s financial position prompted its withdrawal from the Verde transaction. Explaining its withdrawal from the process in April 2013, Co-op Bank spoke obliquely of “the impact of the current economic environment, the worsened outlook for economic growth and the increasing regulatory requirements on the financial services sector in general”. However, Co-op Bank’s former Chief Executive, Barry Tootell, gave a franker admission: he told the Committee clearly that he recommended to Co-op Bank’s board, and to group Chief Executive Peter Marks, that Co-op should not pursue the transaction because it lacked the capital strength to do so. (paragraph 167)

There is reason to think that the frailty of Co-op Bank’s capital position could have been discovered sooner—specifically, if the bank had monitored its loan book and its treatment of customers more effectively, and if it had accounted for its banking IT programme in a different way. Had Co-op Bank’s resulting capital shortfall been uncovered earlier, it is likely that the bank would not have progressed so far with Verde. As it was, the rapid and late emergence of the capital problem led to Co-op’s withdrawal from the Verde process at a relatively late stage. The Committee recommends in paragraphs 127, 128 and 155 that the FRC investigation and the independent inquiry into the events at Co-op Bank consider the role of KPMG and the FSA in relation to the late emergence of loan impairment and IT losses. On the basis of these findings, the independent inquiry into the events at Co-op Bank should also form a view on whether Co-op’s Verde bid could or should have been halted sooner. (paragraph 168)

Chairman's comments

“While it may not have been fully transparent from the start that Co-op Bank’s bid was doomed to failure, it was beset by problems from an early stage. But it was not these problems that killed the deal—it was the capital shortfall that emerged only late in the day.

“An important outstanding question is whether Co-op Bank’s capital shortfall could or should have been uncovered sooner. The FRC’s investigation and the Treasury-commissioned inquiry into Co-op Bank need to examine this in depth.”

Co-op Bank’s capital shortfall

Attempts have been made to paint Co-op Bank’s impairment losses as the result of a shift in the regulatory goalposts. The Committee does not agree. The PRA’s capital exercise applied to a number of banks, and only Co-op Bank was so badly affected. Co-op Bank’s impairment losses were primarily the result of its own, and Britannia’s own, poor-quality lending. The late emergence of these losses appears to have been due to Co-op Bank’s comparatively "loose" approach to recording impairments, which was uncovered only once the FSA began its capital exercise in late 2012. (paragraph 125)

Co-op Bank’s approach to recording its impairments in the years running up to 2013 was described by Andrew Bailey as "looser" than the rest of the industry. This should have been clear to Co-op Bank’s management—to all those responsible for risk and accounting, including the board, relevant executives and committees. It should also have been apparent to Co-op Bank’s auditor—KPMG—and to the regulator—for the period in question, the FSA. (paragraph 126)

The Committee is surprised that, in spite of the evidence it has heard, Co-op Bank’s former auditors, KPMG, maintain that Co-op Bank was not an outlier in terms of its impairments. The FRC’s inquiry into the approval and audit of Co-op Bank’s financial statements should determine precisely how Co-op Bank’s approach to recording impairments differed to that of other banks, and why KPMG apparently failed to uncover this. The independent inquiry into events at Co-op Bank should also look closely at the shortcomings of the bank’s auditor, KPMG, and its apparent failure to ascertain the extent of the impairments. In so doing, the inquiry should look to see if any shortcomings are unique to the KPMG relationship with Co-op. (paragraph 127)

The losses emanating from Britannia stemmed predominantly from its commercial loan book. The due diligence performed on this book has proved to have been totally inadequate. KPMG’s initial due diligence was based on incomplete information. Further due diligence, which KPMG recommended be performed, was carried out by Co-op Bank itself. Co-op Bank’s work has been described by Sir Christopher Kelly as "cursory" and "limited". The provisions against future losses, made on the basis of the due diligence, were far too low. (paragraph 130)

The Committee is surprised that the additional due diligence—a crucial piece of work—was allowed to be performed to such a low standard. KPMG should have given clear guidance to Co-op Bank about the standard required. The Committee is also surprised that, despite recommending the additional due diligence, KPMG did not scrutinise it once complete. If KPMG considered it outside its remit to examine Co-op Bank’s own due diligence, it could still have given particular attention to the inherited Britannia assets in future annual audits; the FRC investigation should examine whether or not KPMG did so. (paragraph 131)

Given the evidence it has heard, the Committee is very surprised by JPMC’s statement to the Co-op Bank board at the time of the merger that the Britannia due diligence “exceeded that normally undertaken for listed companies”. This is not reassuring about the typical quality of professional advisory work, particularly given the substantial sums often involved—KPMG and JPMC received £1.3 million and £7 million—and the important advice and guidance they provided on the Britannia transaction. The Committee expects the independent inquiry into the events at Co-op Bank to examine whether the work provided by KPMG and JPMC met a reasonable standard, in substance as well as form. (paragraph 132)

The PRA—the FSA’s successor body as prudential regulator—admits that, with better supervisory tools, Co-op Bank’s problems would have been uncovered by the FSA sooner. It was the development of these tools—as part of the transition to the new approach to regulation in which the FSA and now the PRA have been engaged—that led to Co-op Bank’s impairment losses being revealed. The independent inquiry into the events at Co-op Bank should consider whether the FSA could or should have developed better supervisory tools earlier, and hence uncovered Co-op Bank’s impairments sooner. The inquiry should also consider whether Co-op Bank’s impairment profile—which appears to have differed from that of other banks throughout the financial crisis—should have led the regulator to inspect it more closely prior to 2012. (paragraph 128)

While it had no effect on the extent of the write-off, the accounting treatment that Co-op Bank adopted for the IT programme had a significant influence on the timing of the impact on the bank’s capital position. One method of accounting—funding the programme directly through the bank—would have ensured that the costs of the programme were deducted from Co-op Bank’s capital position as they were incurred. The method adopted—financing the programme through a service company owned by the bank—meant that the full cost was recorded over a six month period as the programme was paused and then cancelled. The FRC should consider as part of its investigation whether this accounting treatment was appropriate. The independent inquiry into the events at Co-op Bank should establish whether this accounting treatment was brought to the attention of the FSA, and whether the FSA should have foreseen and acted on its consequences. (paragraph 155)

Chairman's comments

“Co-op Bank’s huge losses on the Britannia assets remained uncovered for years despite numerous audits by KPMG. The Financial Reporting Council’s investigation needs to find out how something so important came to be overlooked. This may need to consider not only the work by KPMG but also the merits of the audit process for banks.

“Furthermore, the role and apparent shortcomings of the FSA in supervising Co-op Bank should also be considered by the independent inquiry commissioned by the Treasury. It is important, from every angle, that the inquiry determine why the capital shortfall was not uncovered earlier.

“The impending inquiries should also examine further the apparently wholly inadequate due diligence on the Britannia merger. They will also need to look at the accounting treatment of the bank’s disastrous IT replacement programme.

“It could turn out after closer scrutiny by the auditor and regulator could and should have identified these problems before they became so severe. Nonetheless, the former management of Co-op Bank bears primary responsibility for the calamity that has befallen it.”