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Rating Action:

Moody's downgrades Co-operative Bank; on review for further downgrade

Global Credit Research - 09 May 2013

Baseline credit assessment lowered to b1

London, 09 May 2013 -- Moody's Investors Service has today downgraded the deposit and senior debt ratings of Co-operative Bank plc to Ba3/Not Prime from A3/Prime 2, following its lowering of the bank's baseline credit assessment (BCA) to b1 from baa1. The equivalent standalone bank financial strength rating (BFSR) is now E+ from C- previously.

The lowering of the BCA reflects Moody's opinion that (1) the bank faces the risk of further substantial losses in its non-core portfolio, as demonstrated recently by the unexpectedly significant deterioration of its commercial real estate (CRE) exposures, that will exert downward pressure on capital ratios that are already low relative to its peers'; (2) its vulnerability to losses is heightened by the low level of provisions held against its lending portfolio; and (3) the bank's slow progress in realising merger-related revenue and cost benefits has diminished its ability to replenish capital through earnings. Together, these imply a risk of write-downs on junior debt instruments and, potentially, the need for external support to maintain regulatory capital levels. These risks are incompatible with a BCA above the 'b' category.

Consistent with the lower b1 BCA, Moody's downgraded the ratings of the bank's subordinated and junior subordinated debt to B2 and B3 (hyb), respectively, from Baa2 and Baa3 (hyb).

Moody's is maintaining the one notch uplift from the BCA that it incorporates into the deposit and senior debt ratings reflecting the assumption of a moderate potential for systemic support likely to be forthcoming from the UK authorities in the event of need for a medium-sized institution such as Co-operative Bank.

Moody's has also extended the review for downgrade -- initiated on 30 July 2012 -- on all the bank's long-term ratings and BFSR. The review for further downgrade will allow Moody's to examine the effectiveness of the bank's plan to strengthen its capital structure, improve profitability and reduce its cost base once the full implications of the Prudential Regulatory Authority (PRA) review are known by the bank, which is not expected until end-May 2013.

RATINGS RATIONALE

The lowering of the BCA to b1 reflects Moody's view that the bank's 2012 revaluation of its risk exposures announced in March indicates that the significant deterioration in the credit quality of the bank's non-core portfolio has exceeded the bank's expectations and that its earlier valuation reserves and provisions built against these risks may well be inadequate. Most of these risks stem from the legacy portfolio of Britannia Building Society, which the Co-operative Bank acquired in 2009. Moody's believes that the bank underestimated the risks of that acquisition, especially against the backdrop of the continued weak economic environment. Moreover, the bank's ability to generate the earnings needed to replenish capital, if higher losses materialise, is diminished by its slow progress in realising merger-related revenue and cost benefits.

Moody's believes that the combination of (1) low capital levels; (2) a low problem-loan coverage ratio relative to other UK banks; and (3) weak internal capital-generation capacity suggests that the bank's capacity to absorb future losses is now too low to support an investment grade rating and that it possesses only speculative standalone strength, subject to high credit risk in the absence of extraordinary external support. The ratings assigned to the bank's subordinated and junior subordinated debt reflect the possibility that losses may be imposed on holders of these securities in order to achieve the capitalisation levels that the UK regulators require.

--- CAPITAL LEVELS ARE LOW, RELATIVE TO THOSE OF ITS PEERS

The bank reported a Basel 2.5 Core Tier 1 ratio of 8.8% at end 2012 (which improved to 9.2% in January 2013 following a securitisation transaction), which is considerably lower than those of its UK peers. In addition, Co-operative Bank reported a fully-loaded Basel III CET1 ratio of 6.3% (which improved to 6.7% in January). This is already below the new target capital ratio of 7% outlined by the Financial Policy Committee (FPC) before any further adjustments to its capital requirements and or resources that may come as a result of the PRA review, which is responsible for ensuring that UK banks have capital plans that will enable them to meet the 7% target. The prudence of asset valuations and the adequacy of provisions are two areas of focus under the PRA's review. The bank's particularly low CET1 ratio is driven by substantial capital deductions for anticipated losses in excess of the currently low level of provisions on the non-core portfolio, which accounts for approximately six times its Tier 1 capital, highlighting its weak loss-absorption capacity.

--- CRE EXPOSURES PROMPT INCREASE IN PROBLEM LOANS

According to Moody's calculations, the bank's problem loan ratio increased to 10.9% at year end 2012 from 8.1% in 2011. Although the non-performing loan ratio of the bank's core portfolio remains stable, the quality of its non-core book has significantly weakened due to the deterioration of its CRE exposures. The considerable increase in impairments indicates that the initial fair-value protection created following the merger with Britannia Building Society significantly underestimated the losses this portfolio would experience. In addition, the limited efforts to effect asset disposals, compared with UK peers' aggressive deleveraging of non-core assets, may have resulted in the bank overestimating asset values and underestimating potential expected losses.

--- 2013 PROFITABILITY WILL REMAIN SUBDUED; BALANCE-SHEET DELEVERAGING COULD IMPROVE CAPITAL RATIOS

Moody's considers that the bank's profitability will remain subdued during 2013 due to low interest margins, further losses in its non-core portfolio and a high cost base, as reflected in its reported cost to income ratio of 74% at year end 2012, which is high for a retail/SME-focused bank in the UK. Co-operative Bank posted a loss before taxes of GBP673.7 million in 2012 compared with a profit before tax of GBP54.2 million in 2011. The loss was mainly driven by a significant increase in impairment losses to GBP468.7 million (GBP114.9 million in 2011), close to four times the impairment losses recorded in 2011.

Moody's believes that Co-operative Bank is unlikely to be able to generate a significant amount of capital through earnings. As such, to maintain capital ratios at the level required to satisfy its ongoing regulatory objectives, Moody's would expect to see the bank deleveraging its balance sheet and receiving additional support from its parent (Co-operative Banking Group Ltd (unrated)) following their announcement to dispose some assets, such as its life and general insurance businesses. Moody's believes that there is material uncertainty as to whether these actions alone will be sufficient to maintain the capital base at the required level given the losses the bank may experience in its non-core portfolio.

--- DECISION TO CANCEL VERDE ASSETS ACQUISITION IMPLIES THAT ANY FUTURE GROWTH WILL NEED TO BE ORGANIC

Co-operative Group also announced on 24 April 2013 that it would no longer proceed with the acquisition of the assets and liabilities (known as "Verde") that Lloyds Banking Group has been required to sell by the European Commission. While the abandonment of the deal is not a material driver of today's action, had it proceeded to completion the deal would have strengthened Co-operative Bank's franchise and increased its customer base. However, Moody's believed that the deal would have also posed a number of challenges in terms of capital, liquidity and execution risk. Its abandonment implies that future growth targets will be met through organic growth, which Moody's considers as challenging given the bank's current capital position.

WHAT COULD MOVE THE RATINGS DOWN/UP

Negative pressure on Co-operative Bank's ratings would stem from further deterioration in its Core Tier 1 capital driven by further loses or insufficient remediation actions to maintain and increase capital ratios above minimum regulatory requirements. In addition, a further decline in profitability and efficiency ratios would exert negative pressure on the ratings. Since the debt and deposit ratings benefit from systemic support uplift, they remain sensitive to any further changes in Moody's support assumptions or the credit quality of the UK government (Aa1 stable).

There is no short-term upward pressure on the ratings, reflected by the review for downgrade. However, in the long term, upward pressure might develop on the ratings following (1) significant improvements in the bank's capital position; (2) further reductions in its non-core portfolio; and (3) improvements in its profitability and efficiency ratios.

The principal methodology used in this rating was Moody's Consolidated Global Bank Rating Methodology published in June 2012. Please see the Credit Policy page on www.moodys.com for a copy of this methodology.

REGULATORY DISCLOSURES

For ratings issued on a program, series or category/class of debt, this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series or category/class of debt or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the rating action on the support provider and in relation to each particular rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the ratings tab on the issuer/entity page for the respective issuer on www.moodys.com.

For any affected securities or rated entities receiving direct credit support from the primary entity(ies) of this rating action, and whose ratings may change as a result of this rating action, the associated regulatory disclosures will be those of the guarantor entity. Exceptions to this approach exist for the following disclosures, if applicable to jurisdiction: Ancillary Services, Disclosure to rated entity, Disclosure from rated entity.

Please see www.moodys.com for any updates on changes to the lead rating analyst and to the Moody's legal entity that has issued the rating.

Please see the ratings tab on the issuer/entity page on www.moodys.com for additional regulatory disclosures for each credit rating.

Carlos Alberto Suarez Duarte
Asst Vice President - Analyst
Financial Institutions Group
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Johannes Felix Wassenberg
MD - Banking
Financial Institutions Group
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Releasing Office:
Moody's Investors Service Ltd.
One Canada Square
Canary Wharf
London E14 5FA
United Kingdom
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's downgrades Co-operative Bank; on review for further downgrade
No Related Data.

 

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