Societies should have a big future

With building societies\' margins under pressure, greater scale and more diversification will be needed if the sector is to survive to serve future generations, says Graeme Johnston

Building societies large and small are under siege. Competition in the financial services market is more intense than ever. Societies are being attacked by each other, by banks, by other direct lenders and by the internet. Even the high street retailers are getting in on the act, taking market share and putting pressure on margins.

Profitability in their core market, mortgages and savings, is becoming harder to achieve – to some it is nigh on impossible – and societies have been looking at fresh ways to define themselves and invest in their future. Pressure has also been growing to make the most effective use of the capital base.

Many have diversified, and there can be no doubt we are also seeing a shift in attitude among societies towards mergers. The independence of many is slowly being replaced with a recognition that to successfully compete they must increase their scale, market share and more importantly, do something different – but only if they can be the dominant party. This is their dilemma.

The number of societies has certainly dwindled over the years with six listings and four takeovers among leading players since 1989, as well as eight mergers over the past 10 years including, most recently, Portman and Staffordshire.

Experts were predicting the end of mutual societies during the massive upheaval of the 1990s. Many societies, with their inherent financial muscle, have since recognised their core strengths and continue to gain momentum against their competitors, carving out a niche for themselves. Client service is still a big differentiating factor for building societies and something they are unlikely to sacrifice in order to grow.

But as financial products become more sophisticated the big banks are starting to dominate the landscape and societies are looking to diversify into new areas. Some recent examples of diversification include West Bromwich’s acquisition of mortgageforce and Principality’s acquisition of Loan Link, both of which are loan brokers.

But why has the landscape changed? On the face of it building societies are in a strong position. They have no shareholders to pay dividends to, should have more attractive pricing, and they are less profit driven. They can therefore plough more of their profits back into growth. The reality is that many societies have seen stable or low levels of growth and higher than usual levels of competition, resulting in greater margin pressure in their core markets. These gross margins are then almost completely absorbed by, at times, excessive operating expenses.

The margin squeeze is being caused by several factors. Some larger competitors are lending at narrow margins to capture or retain business, take market share or win other banking business. Additional income can also be earned from the cross-selling of other products such as house and life insurance. This is forcing societies to look for ways to improve their positions.

The rate tarts out there are making the most of this on both the lending and saving sides, compounding the issue for many societies. In the short term it is consumers and, to some extent, brokers who are benefiting from these pricing levels. These challenges are limiting growth and profitability. Unless action is taken to remedy the situation building societies are likely to lose their historic levels of market share and will struggle to survive. But what does the future hold and how can these challenges be addressed?

Building societies have not yet conceded defeat. There are those that have weathered the storms better than others and have continued to increase their profits despite falling margins by keeping a close eye on their back office costs.

Many are also showing their entrepreneurial flair by producing innovative products and using other methods of increasing profitability such as moving into the sub-prime market either through acquiring portfolios or developing their own products, sometimes with external partners.

Others are moving away from retail and offering commercial mortgages and asset finance. But this strategy is likely to come at a cost.

These products do not come naturally to some building societies who have looked after the same client types for more than a hundred years. The required skills are therefore more likely to be gained through recruiting specialist staff – which means taking time to achieve critical mass in the market – or a strategic acquisition to achieve an instant presence.

Also, more societies have expressed an interest in, or are currently contemplating, merging. Organic growth among building societies tends to be slow and by increasing scale they should be able to spread the costs of administration, the impact of regulation, lessen funding constraints and counter low margins. A merger is therefore attractive as it provides a society with the opportunity to gain skills, acquire a new customer base, cross-sell products and widen geographic reach without mutuals having to expose themselves to unnecessary risk. But while this all looks good on paper, the integration and people aspects of such deals – both at the top of the organisation and in the back office – should not be ignored.

As banks increasingly target the retail market and societies continue to have their margins squeezed, there is no doubt there will be more changes to the building society landscape. The values of the society model do not necessarily have to change but there must come a time when the societies have to act in order to maintain their presence in the financial services marketplace. There will always be a place for these historic providers of mortgages and savings in our society but they must take some drastic steps to ensure they are still around to serve future generations.

Greater scale and diversification will be needed if mutuals are to be successful in the longer term. For the outside observer it will be fascinating to see if societies grasp the nettle or if they allow the moment to pass.