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Merging Market

Competitive and regulatory pressures have pushed building societies into mergers, but Harvey Jones examines whether they are good for brokers and their clients

The proposed merger of Nationwide and Portman is the latest in a string of building society consolidations, with more expected to follow. But are they are a sign of strength in the sector or debilitating weakness?

Look at the recent acquisitions. Last August, Leeds took over Mercantile. In September, Portman gobbled up Lambeth. And in December, Newcastle ab-sorbed Universal.

You can call them mergers if you like, but Universal, Lambeth and Mercantile have gone for good, their names and identities dumped into the dustbin of financial services history. These are the first mergers seen in the sector since December 2003, when the Derbyshire swallowed Clay Cross and Portman made short work of Staffordshire. Who remembers them now?

More mergers can be expected this year, according to accountancy firm Deloitte. It predicts five in total, as mu-tuals are forced to get leaner and smart-er to survive.

Stephen Williams, head of the building societies team at Deloitte, says the mergers will be driven by two factors – one defensive, the other offensive.

On the defensive front, struggling building societies are nervously hunting around for ‘white knight’ mutual partners. But the bigger players don’t have altruism on their minds.

“The larger building societies will be looking to increase scale, reduce the costs of funding and acquire key capabilities and assets to leverage across their business,” he says.

The big boys are desperately playing catch-up with the banks, which can boost their economies of scale with cross-border merger and acquisition activity. But building societies have to find more homespun ways of keeping costs down.

But a spokeswoman for the Building Societies Association denies that consolidation is a sign of weakness.

“After all, total assets and the number of members remain the same,” she says. “Building societies are and will remain an important part of the financial services industry and will continue to flourish by offering good value to their members.”

She also expects further mergers to follow, but this won’t be the whole story.

“There’s no doubt many societies will be unaffected by the process and will continue to meet their members’ needs through organic development,” she adds. “The beauty of the sector is its diversity.”

The spokeswoman argues that lar-ger societies challenge identikit banks and the local knowledge of smaller and regional ones allows them to offer consumers something different. But won’t consolidation threaten this diversity?

Rob Proctor, deputy chief executive of Kent Reliance, suggests recent mergers weren’t as cosy as they were publicly portrayed.

“Lambeth was hung out to dry, unaware of the Nationwide takeover when it threw in the towel and disappeared into Portman,” he says.

“The closures of Lambeth and Staffordshire were followed by widespread branch and administrative centre closures,” he adds.

“Societies should not sacrifice themselves at the altar of mutuality, because history shows this gives them no guarantee of retaining a separate identity.”

Only a handful of societies retain a general regional franchise, and Proctor warns this will be further eroded by the growing popularity of internet, telephone and postal accounts.

“More people will follow the higher rates offered by low-cost direct pro-viders and stick with their local building society branches,” he says. “Everyone says they support their local corner shop, but in reality the majority shop at Tesco.

“Some 20 years ago, people bought their car insurance on the high street and now they buy it from their supermarket or online. The same thing is likely to happen with societies.”

Proctor suggests building societies have struggled to establish standout identities.

“Only a small number, such as Teachers and Catholic, have customer-focussed unique selling points,” he says. “But with growth of 10.7% and 4.25% respectively, they are hardly setting the world alight.”

Proctor modestly fails to mention that Kent Reliance has one or two USPs of its own, notably its inter-generational mortgage, launched to great press fanfare, which helps families avoid Inheritance Tax by allowing parents to pass their mortgages onto their children.

Britannia also has a unique offering that allows it to stand out from the crowd, says its chief executive Neville Richardson.

“We feel it is important to share our success and rewards with our members,” he says. “The Britannia Membership Reward scheme returns a share of our profits to members every year to reward their loyalty. This year, 900,000 members took a slice of more than £51m thanks to this profit-sharing scheme.”

Richardson says mergers can benefit members and cites the case of its £150m acquisition of Bristol & West’s savings business and branch network.

“This gave us an enhanced branch network, 700,000 more members and 700 new staff with new ideas,” he says. “It also delivered an extra £4bn of retail deposits, helping us to grow the business by about one-third.”

The deal struck a blow for mutuality by creating the first major re-mutualisation of a former building society.

“As a mutual society we recognise the importance of listening to and learning from our membership,” says Richardson. “By providing opportunities for two-way communication, we can show what it means to be members of a society, not just customers.”

Britannia will consider further consolidation if it spies the right opportunities, he adds.

John Carrier, chief executive at Scarborough, says mutuals can differentiate themselves by offering long-term value and innovative products.

“Our blend of core business investment and diversification through our third-party mortgage administration subsidiary SMS, sub-prime lender Scarborough Specialist Mortgages and offshore deposit-taking business Scarborough Channel Islands will ensure we optimise profitability in line with our underlying principle of returning added value to members,” he says.

The increased cost of regulation, compliance and the need to update IT platforms are likely to drive future building society mergers. The newcapital adequacy framework now being implemented under the European Union’s Capital Requirements Directive will also have an impact.

CRD is the European Union law that implements the international Basle II recommendations on banking laws and regulations. Here in the UK it is being pushed through by the Financial Services Authority.

Basle II imposes regulatory capital requirements to govern how much capital banks and building societies must hold back to protect their members and aims to make capital allocation more risk-sensitive.

How much capital societies must retain in future will be determined by their approach to Basle II – whether they sign up to the standardised agreement whereby the FSA stipulates the level of capital, or opt for the Internal Ratings Basis approach which enables firms to set their own levels, as Norwich and Peterborough and Alliance & Leicester did in December 2006.

A spokeswoman for N&P, which recently became the first company in Europe to obtain a waiver to adopt the IRB approach, says the directive could help building societies break new ground.

“Basle II gives us greater flexibility by allowing us to introduce risk-based pricing and lower interest rates for low-risk customers,” she says. “Because they are less likely to default, less capital is held against their mortgages.”

Lenders that obtain the IRB waiver will gain a competitive advantage, because they can risk-grade all their business and offer better rates to lower-risk borrowers. Without the waiver, UK lenders must allocate the same percentage of capital to each mortgage to protect them from bad debts, regardless of borrowers’ risk profiles.

“They can write more business as long as it’s good quality and generates higher profits,” the N&P spokeswoman says. “It may also allow them to release capital to write more business.”

N&P has used its Basle II waiver to underpin all the lending underwritten through Astra, its broker-focussed buy-to-let subsidiary, which launched on June 1.

The N&P spokeswoman warns that societies and other lenders that don’t achieve IRB status could come under extra pricing pressure, which in turn could drive further mergers.

So what of the company behind the UK’s most controversial society mer-ger? A Nationwide spokeswoman says brokers should see little difference in service from the post-merger society.

“It will continue to be a mutual building society owned and run for the benefit of its members, offering brokers attractively-priced products and re-maining highly competitive in its chosen markets,” she says.

She claims there will be spin-off benefits for brokers due to the society’s aim to improve its broker-generated mortgage lending operations.

“It will also create a wider range of specialised mortgage products for brokers to consider, including self-cert, buy-to-let and sub-prime mortgages,” she adds.

But hitherto there’s been little evidence that the merged society will have a business development management sales force in place.

But as Nationwide’s newly app-ointed chief executive Graham Beale exclusively revealed in Mortgage Strategy last week, the society’s relationship with brokers is high on its agenda and a BDM network is in the works.

The enlarged society will generate economies of scale to help it boost growth in core markets and play a leading role in developing a healthy mutual sector that champions consumers, the Nationwide spokeswoman claims.

And, she adds, the next 10 years are full of promise.

“Building societies have proved they can be just as innovative with products while offering transparency and value to members,” she says. “Mu-tuals tend to offer more competitive mortgage rates than banks, both initially and over the long term, and they levy fewer fees and charges.”

She believes consumers want more open, ethical and friendly financial services providers, and this gives societies the edge over banks.

“Many people have negative perceptions of banks, seeing them as evasive and profiteering,” she says. “This gives building societies an opportunity to differentiate themselves.”

And she backs suggestions that regulation could drive further mergers.

“Any new regulatory requirements will need to be interpreted effectively to ensure societies are compliant within a given timescale,” she says. “For some societies, this could be challenging.”

Building societies have drawn flak for their executive remuneration policies and for failing to engage with members, but the Nationwide spokeswoman believes they have learnt their lessons from the carpetbagging and demutualisation campaigns of the late 1990s.

“More building societies are choosing voluntarily to comply with the high standards of corporate governance that apply to public limited companies,” she says. “There has been a big increase in the numbers holding advisory votes on directors’ remuneration, with members strongly endorsing current policies in every vote.”

The N&P spokeswoman agrees.

“Arguments over remuneration and mutuality should be buried for good,” she says. “Both have been done to death and settled in the mutuals’ favour without question.”

Proctor says building societies have been an easy target for critics of remuneration.

“Building society executives don’t benefit from share options, golden handshakes or golden handcuffs, but are dependent upon their salaries,” he says. “Quite rightly, these are transparent and overall packages are many times below those available in the banking sector.

“However, they are still high when compared with the wages of the majority of their savers.”

Proctor believes societies are well placed to meet the spirit of regulation, because they have treating customers fairly in their blood.

“They were established on social and moral grounds and continue to serve the financially excluded rather than concentrating on high net worth customers, as targeted by the banks,” he says.

“Societies have been treating customers fairly rather than maximising shareholder profits long before the Financial Services Authority claimed to invent the principle with its TCF initiative,” he adds.

By contrast, brokers have found TCF more challenging and could learn from building societies, he says.

“The majority are primarily driven by fees and commission,” says Proctor. “Over the years many have adopted principles of best advice, knowing their customers and acting fairly, but it only comes naturally to a few.

“TCF still causes problems for them because of the imperative of completing sales and paying the bills,” he adds.

Proctor explains that networks, larger brokerages and expensive compliance officers, all paid for by customers, may tick all the right boxes with the regulator but are more a case of form over substance.

“Both the Financial Services Act and the Financial Services and Markets Act may have reduced the number of rogue players,” he says. “But if brokers continue to be remunerated by the companies they introduce business to, their recommendations will be influenced by the amount they’re paid.”

But Steve Cox, operations director at Spicerhaart Financial Services, says brokers have little to learn from societies when it comes to TCF.

“TCF is applicable to all financial services companies, from small independent brokers to large building society networks,” he says. “With all these companies putting compliance systems in place to conform to TCF, building societies are not necessarily ahead of brokers.”

Broker Cath Hearnden, director of My Mortgages Direct, also rejects claims that building societies are paragons of corporate governance and TCF, or that brokers have anything to learn from them.

“I haven’t seen enough evidence that building societies are any better than any other financial services company,” she says.

Societies tend to have better service standards, Hearnden says, but this is more down to size than mutuality.

“Many small societies have the edge in service, but Nationwide doesn’t,” she adds.

Banks’ service levels may be poor, but many have at least built good on-line systems and processes to make life easier for brokers, she adds.

Hearnden says recent society mergers have had little direct impact on what brokers offer their clients.

“In the longer term, mergers could reduce the number of products available, but all we can do is what we always do – source the best deals for our clients.” •

Consolidation is the story wherever you look
Paul Chafer is sales and marketing director at Stroud & Swindon
Consolidation among building societies has been expected for some time. But it’s not just building societies that are subject to this phenomenon – it’s a feature of most industries. Just look at Somerfield and Kwik Save and the potential Barclays and ABN Amro merger. Consolidation is the name of the game in many sectors.

Increased competition in the retail financial services market, driven by aggressive growth, market share targets and new entrants, continues to bite. All providers are challenged to cut costs by increasing the efficiency of their operations.

Margin and peripheral income are key, although they are under pressure too. It is unlikely that this pressure is going to ease and this may result in further mergers, but I believe the numbers will be small.

Some forecast there will only be one building society merger in 2007 besides Nationwide and Portman and this seems realistic. I’d be surprised if any others were announced.

We have no merger plans and are focussing our efforts and resources on improving our core business. But we think the world will become ever more challenging for some societies and they may decide that the most appropriate way forward is to merge with a larger partner.

Building societies are still relevant and this is evidenced by their continuing appearances in the best buy tables for both mortgages and savings. They have a history and reputation for innovation and responsiveness. These factors will become more important in an increasingly competitive market.

But as far as the public is concerned, the line between banks and building societies has become blurred, with many consumers unable to accurately place Nationwide, Cheltenham & Gloucester or Northern Rock in the appropriate category. This questions the relevance of mutuality in the eyes of consumers.

For the vast majority of mortgage and savings customers, mutuality is not a driver in helping them to decide upon the organisation they choose to do business with.

Similarly, I don’t believe that branding is a great differentiator. With customers choosing on the basis of price and company reputation, their decision-making is more a consequence of online information gathering than anything else.

So we operate in an ever more demanding market, but as a result it has had to become more innovative and responsive. This trend will continue.

No imperative to merge in a benign market
John Wriglesworth is a housing economist
When Nationwide announced its intention to take over Portman last September, it sparked speculation over the future of the building society sector. The press reported that this was just the beginning and there were expectations that other mergers would soon follow. However, the expected levels of consolidation haven’t transpired.

“Everyone was talking to everyone else,” said one senior executive, but that was as far as it went.

The Portman and Nationwide merger plans aren’t defensive, as both societies have outstanding five-year track records. But the merger will allow them to create an even more powerful presence in the market, taking the best from both business models and capitalising on huge economies of scale.

However, the hours spent analysing the strategic implications of the Portman deal did not lead building society boards to conclude they had to follow. After all, there is no underlying reason to radically restructure the sector.

There’s no overwhelming pressure on major societies to merge. While it is undeniable that the market is becoming more competitive, most of the larger societies have maintained good results. This is because they are able to leverage the competitive advantages their mutual status gives them and have sufficient scale to invest in their businesses, building on their efficiency and customer-friendly status.

Since the mid-1990s, we have seen a period of sustained growth and benign trading conditions in the housing market. However, should there be property crash similar to the early 1990s, this picture would change.

If societies’ mortgage books saw huge credit losses as they invested millions to manage arrears and collections, consolidation would stop being an option and become an imperative.

But this isn’t the case today. Despite recent base rate rises, mortgage rates are still at a historically low level and nowhere near the 15% levels that precipitated the last recession.

Instead, the major societies are strengthening their positions and branching out into new markets. Increased competition has seen major brands like Britannia and the Yorkshire develop successful ventures in sub-prime lending. And they’re not alone. Other large societies including Coventry aren’t far behind.

Large building societies with lean business models represent a growing threat to existing players in the specialist market, where lending capacity is expanding at great speed. As returns in these markets inevitably fall, the building societies will be even better placed. The mutual sector is flourishing and remains a force to be reckoned with.

Mercantile merger allowed us to expand our reach and diversify
Ian Ward is chief executive of Leeds
Most pundits who forecast societies’ rapid demise have been proved wrong, with just four mergers in the past five years, although most have occurred in the past 12 months.

Our merger with Mercantile was completed last August, giving us 13 extra branches in the north-east of England. Of course, there will be other mergers and I believe that these could occur irrespective of the societies’ size.

But if societies deliver consistent success and want to remain independent, members will support that. We’re determined to remain a successful independent building society and will do this by providing excellent value through good service, cost-efficiency and competitive products.

However, societies whose senior executives and directors aren’t committed to independence are likely to merge.

Our lending success has been achieved by selling mortgages through a variety of channels, combined with diversifying our products and criteria and backed up by responsive service. We have seen growing volumes across all channels and in particular the broker market, which is important to us.

In addition to our existing lending throughout the UK and Gibraltar, we have expanded our overseas operations to encompass Spain and the Republic of Ireland. Other societies have diversified even more than us. Providing they execute their strategy effectively, this can prove successful.

Our merger with Mercantile was based on the long-term interests of its members, bringing the benefits of greater size and an increased number of products while retaining the advantages of mutuality.

If the senior executives and directors of other societies are considering mergers, they should investigate the option fully and gather advice from within the sector, rather than using costly external consultants.

I believe the mutual building society sector is strong. As long as we deliver value for money products and good service, members will continue to support our independence and the management teams and staff who are delivering this success.

Members have the opportunity to elect board directors and then re-elect them every three years. They also vote on directors’ remuneration each year.

While this is not a legal requirement, most societies follow this practice in the spirit of their plc rivals’ corporate governance requirements.

Mutuality also means that we are a one-member, onevote business, so customers with £100 invested have the same rights as those with £1m. This is where we part company with plcs, where institutional shareholders cast the majority of votes.


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