T he crisis at Co-operative Bank has raised troubling questions about a model that many people had come to see as the best answer to the banking crisis: friendly, local lenders not bent on profit and speculation, with an ethical purpose and long-term goals. To discover that Co-op Bank was riddled with poor business practice and chaired by a person of doubtful character is a serious blow.

“Friendly” banks – that is, a wide variety of types owned by members and customers rather than shareholders – are hugely popular around the world, with an estimated 20 per cent of the market for deposits and loans in Europe alone. But they have always had a problematic side, largely because society tends to be indulgent towards them. Typically, they enjoy strong political backing, and may even get special regulatory treatment on the grounds that they serve the public good and do not take excessive risks.

This has led to an uneven history for friendly lenders. While the sector as a whole weathered the recent crisis better than its commercial counterparts, it has generated serious problems in Ireland, Spain and Cyprus, and now the UK. There have also been rumblings in France, Germany, Austria, South Korea and, in an earlier period, in the US, with the crisis in its savings and loan sector in the 1980s and 1990s.

There are many common threads to friendly banking crises. One is governance. At troubled lenders, boards often lack the independence needed to run a healthy institution. Cronyism, political affiliation, personal connection determine who wins a board seat, rather than appropriate experience and qualification. Although regulators should test candidates’ fitness and properness for the role, this does not always happen because of political pressure or regulatory indulgence.

Another is the darker side to the personal character of community banking. It is all very well to advance a loan to Mr Smith down the road because you know all about him: it is harder to call in that loan when things go wrong. This is how friendly banks can build up a huge backlog of bad debts.

A third common thread is regulation. In many countries, friendly banks have special regulatory regimes. In the Netherlands, one of the stars of the scene, Rabobank, enjoys a higher degree of self-regulation than commercial lenders, albeit under the eye of the central bank. In Cyprus, where I have recently spent much time, co-ops had their own regulator but this did not prevent them building up bad loans amounting to more than 40 per cent of their assets.

A subset of regulatory risk is the frequently encountered view that friendly banks deserve lighter regulation because they do not engage in risky business. In Spain nearly all of the savings banks, or caixas, had to be rescued from their ill-judged property lending. The further risk in this area is that deregulation to promote competition can also lead to disaster, as happened with America’s S&Ls.

A fourth common thread is that much of the character of this sector is shaped by the strong popular and political support it enjoys, and the feeling of entitlement that follows. Cyprus has just had to mount the third rescue of its co-op sector in living memory, bringing the total rescue bill to €2bn (equivalent to more than 10 per cent of this small country’s gross domestic product). Yet members of the co-ops, who were legally liable for their banks’ losses, were not called on to contribute. The popular will was that the co-ops should be kept as they are.

The question is whether these failings can be corrected without destroying the very thing you want to preserve: “the bank that cares”, as the UK Co-op Bank used to call itself.

Recent events strongly suggest that indulgence towards banks creates a moral hazard: lenders take advantage of it, governance and regulation go slack and trouble follows. This may be acceptable if society wants to preserve conditions for a service that many people favour and would even wish to see replace the commercial banks. But it lacks the discipline and clarity that others also wish to see shaping banking activity in a more demanding post-crisis world, and it needs strong justification.

The writer is former chairman of
the Cyprus Independent Banking Commission, and senior fellow
of the Centre for the Study of Financial Innovation

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