The Co-operative Financial Services group and Britannia, the UK’s second-largest building society, are to merge to form a “supermutual”, a decision that could lead to consolidation of other smaller mutuals.

The two have been talking since September and on Wednesday announced the deal would form a business with £70bn of assets, 9m customers and 300 branches.

It is made possible by a parliamentary bill to remove legislation that prevents mergers between mutuals and co-operative groups.

Co-operative – owner of internet bank Smile – is part of the Co-operative Group. Interests range from travel and food retailing to pharmacy and funerals, with turnover of £10bn.

Neville Richardson, chief executive of Britannia, who will head Co-operative Financial Services, dismissed suggestions that the deal was spurred by balance sheet weakness: “This is something people are crying out for and this is very much owned by customers.”

The new Co-operative may be able to access the government’s insurance scheme intended to ringfence toxic assets on balance sheets, and its pro-forma tier one capital ratio is about 9.8 per cent.

More options for societies

The merger between Co-operative Financial Services and Britannia has been facilitated by a new act laid before parliament this week that for the first time allows different types of mutuals to merge.

The draft instrument, known as the Butterfill Act after its sponsor Sir John Butterfill MP, is expected to become law in March and could pave the way for more consolidation amid the credit crunch.

Neville Richardson, Co-operative’s new chief executive, said the deal could prompt more of the UK’s 55 building societies to explore the option of being acquired by another type of mutual. ‘Potentially, it’s an opportunity,’ he said.

So far, much of the consolidation in the mutual sector has taken place between the UK’s 55 building societies.

Pressure is continuing, with some societies expected to be loss-making in 2008, according to rating agency Moody’s, because of rising impairments from UK mortgage lending and commercial property.

Nationwide, the largest, took over smaller rivals Derbyshire and Cheshire. Yorkshire acquired Barnsley, which had lost £10m through investments in the collapsed Icelandic banks.

Talk has centred recently on West Bromwich Building Society, which has a large buy-to-let mortgage book and which could act as a consolidator of smaller societies.

The new law frees building societies to seek deals with other types of mutuals, including friendly societies, such as Liverpool Victoria, and life assurers, such as Royal London and Equitable Life.

The combined business will deliver more than £60m a year in cost savings. Branches in the same locations will be merged but compulsory redundancies kept to a minimum.

In August, Britannia reported a sharp fall in first-half 2008 profits, from £50.5m to £31.2m, due to rising bad debts, particularly in buy-to-let loans. on Wednesday, Britannia said profits in the second half would reflect its exposure to two failed banks.

Fitch, the rating agency, said Co-operative’s liquidity and funding position should help support the new group.

But it put the bank on a negative ratings outlook, saying: “Co-operative’s historically strong deposit/loan ratio will be somewhat diluted by the addition of Britannia’s larger wholesale funding component.”

It also raised concerns Britannia’s specialist mortgage portfolio was “more susceptible” to the downturn.

David Anderson, chief executive of Co-operative, will leave the business. Co-operative’s Barry Tootell will become finance director of the new group.

Britannia members will become members of the Co-operative Group subject to a vote in April.

Britannia was advised by Citigroup and Allen & Overy. Co-operative was advised by JPMorgan Cazenove and Slaughter & May.

Britannia has 3m members who are paid a customer loyalty bonus each year. This is calculated according to profits made by the society and how long a customer has been with the mutual.

Instead Britannia members will become members of the Co-operative Financial Services which has around 3m active members to which it pays an annual dividend.

This varies according to how many products the members have and how often they shop in the Co-operative Stores for example.

There will be no cash windfall for members in this deal but Britannia members will pay £1 to join Co-operative which will be deducted from their first dividend payment.

The idea is that by putting the two organisations together and forming a stronger, future profitability and dividends will be improved.