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COOPERATIVE BANKS AND THE BENEFITS OF DIVERSITY

David T Llewellyn

European banking is a mix of many different types of banks: public, State, cooperative, mutual and private banks. A particular distinction is made between what might be termed Stakeholder Value (STV) banks (of which cooperative banks are a major component) and Shareholder Value (SHV) banks. The distinction is ultimately about the banks bottom-line objectives and the extent to which profit maximisation is the central focus of business models. In their long history dating back to the nineteenth century, cooperative banks have long been an integral, successful, and well-established part of the financial system in many European countries. They are an important part of the diversity and plurality in European banking and have their own characteristic business models, ownership and governance structures. Cooperative banks have evolved from their origins in the second half of the 19th century, and many have evolved into full-service Universal banks. In terms of the range of services offered, in several cases these institutions appear to be almost indistinguishable from their commercial bank competitors, and compete with them in a wide range of banking markets. Although its rationale is different from when cooperative banks were first established as a response to various forms of market failure, the cooperative bank model remains a strong, successful, and viable business and governance model. There are economic, systemic and welfare benefits to be derived from a successful cooperative sector in the banking systems in Europe. A financial system populated by a diversity of ownership and governance structures, and alternative business models, is likely to be more competitive and systemically less risky than one populated by a single model. My central theme is that cooperative banks make a major contribution to the advantages to be derived from diversity in the European banking sector. A particular feature of European cooperative banking is that there is no single universal model that, in all its detail, is common to every cooperative bank. This means that there is

no completely homogeneous set of cooperative banks across Europe, any more than there is homogeneity within the SHV sector. There is a rich diversity in precise business models, structure and governance. Within this diversity there are, nevertheless, major common features to the cooperative banking model. The European cooperative banking sector can, therefore, be characterised as Commonality with Diversity. This rich diversity within the cooperative bank sector means there is a benefit of diversity at two levels: within the cooperative bank sector, and in the financial system as a whole with the mix of STV banks in general (and cooperative banks in particular) and SHV banks. In both dimensions, there is systemic advantage in having bio-diversity in the financial system. Whilst there is diversity in many dimensions (both within some countries and, most especially, between countries), there is a set of key common features of cooperative banks. The major common and dominant features may be summarised: Although all banks (irrespective of their ownership and capital structure) need to earn profits in order to maintain the integrity and viability of the business, a key characteristic of cooperative banks is that maximising profits and the rate of return on capital are not the dominant business objectives of cooperative banks. The typical cooperative seeks to maximise consumer surplus and the interests of its members. Cooperative banks are essentially owned by their members (who are also customers) and in most cases ownership is at the local or regional level. Cooperative banks are often part of a national network with an integrated structure. The network provides economies of scale and outsourcing benefits for member banks and also services to these banks and their members and customers. There are usually various forms of mutual support within the network. In some countries, these Network Central Institutions perform the role of an internal central bank and an intra-network inter-bank market. In some cases, the apex institution within the network is also a bank in its own right. Cooperative banks have a close proximity to their members and customers. It is rare for a cooperative bank to be listed on a stock exchange although some cooperative banks have subsidiaries which are listed.

Ownership stakes in cooperative banks are not tradable in an open market. As a result, it is virtually impossible for hostile bids for ownership to take place. With some exceptions, the almost exclusive source of capital is their retained profits. Cooperative banks have only limited access to external capital independent of their members. In general, profits are retained within the bank with only limited distributions being made. The capital base of a cooperative bank is essentially an inter-generational endowment held by the cooperative in perpetuity for the benefit of current and future members. Members of cooperative banks are an integral part of their governance structures, and governance arrangements are based on one-member-one-vote.

Whilst there are differences in detail between different cooperative bank models, what they have in common is more significant than the differences, and there are important differences between the generality of cooperative banks and their SHV competitors. In general, cooperative banks have a lower risk profile than SHV banks and were less affected by the banking crisis although a certain amount of collateral damage has been experienced. There have been no outright failures of cooperative banks and none have had to be rescued by governments. Furthermore, Bloomberg calculates that less than three percent of the costs of global banking due to the crisis have been associated with cooperative banks and only two such banks feature in the list of the thirty-four banks with the largest losses. The evidence indicates that cooperative banks tend to be more stable than commercial banks with lower volatility of returns. There are several reasons for this including inter alia: they tend to be focussed more on retail business; cooperative banks have tended to stay with the traditional model of banking (originate and hold) rather than change towards the originate-to-distribute model; they have been less reliant on wholesale rather than retail funding; they have tended to adopt a longer-term business horizon rather than the short-termist pressure to seek short-term profitability; they tend to be more risk averse; and perhaps because members of cooperative banks are also customers. Furthermore, as many cooperative banks are part of substantial networks, there is an element of mutual support and cross guarantee schemes. An additional factor

is that cooperative banks are in many cases more highly capitalised than their SHV counterparts. In many countries, cooperative banks are particularly important for small companies and, because of their local focus and proximity to customers, are able to assess local risks. Agency costs (associated with principal-agent issues) exist in all forms of company structure which are handled differently in different types of company. A lot has been made in the literature of the potential weaknesses of the governance arrangements in cooperative banks compared with their SHV counterparts. This is a complex issue and space precludes any detailed discussion of this important issue. However, because there are imperfections in all forms of governance arrangements (as witnessed by the many enquiries that have been made in many countries into governance arrangements) it is invalid to compare the actual arrangements in one model with a perfect theoretical version of a different model. In truth, there are weaknesses in all governance models. However, competition in the market place can mitigate some of the weaknesses in any governance model. In an uncertain market environment, diversity has advantages as it cannot be predicted what form of corporate structure is best suited to all particular circumstances. The case for diversity includes reducing institutional risk, defined as the dependence on a single view of banking that may turn out to have serious weaknesses under unexpected conditions such as the current crisis. Leaving aside the merits of any particular business model, there are powerful systemic benefits to be derived from diversity of business models and ownership structures in the banking sector: A strong cooperative bank sector is likely to enhance competition because cooperatives have a different business model compared with SHV banks.
Because cooperative banks are not owned by large investment institutions, they

are not subject to the short-termist pressure of the capital market which at times induces SHV banks to take excessive risk.

5 There is a benefit to be derived from a mixed ownership structure in the financial system, and the systemic value derived from mixed corporate governance arrangements.
Many cooperative banks are locally based and have a particular focus and

expertise on the local community. This reduces powerful centrifugal tendencies in the financial system. Cooperative banks play a special role in fostering local and regional development by mobilising savings and lending out funds in their own region and in the process limit the extent of capital drain from a region. As argued in the recently published CEPS report on cooperative banks, by virtue of their ownership and capital structure, cooperative banks are designed to perpetually accumulate capital which contributes to mitigating intertemporal risk by creating reserves in good times and releasing them in bad. There is empirical evidence that shocks in countries in which banking systems have a significant STV sector affect the economy less than in countries whose banking systems are based exclusively on SHV banks.

There is a potential systemic advantage in having a mix of institutions with

different portfolio structures with the potential to reduce overall systemic risk. A pluralistic approach to ownership is likely to be conducive to greater financial stability and regional growth. With their contrasting capital structures, business strategies, and governance arrangements, SHV and cooperative banks balance their risks and activities differently. Systemic risk is thereby reduced. The more diversified is a financial system in terms of size, ownership and structure of businesses, the better it is able to weather the strains produced by the normal business cycle (in particular avoiding the bandwagon effect), and the better it is able to adjust to changes in consumer preferences. Having a financial system populated by a diversity of organisational forms is as significant as the merits and drawbacks of each particular form of organisation. The case for sustaining a powerful cooperative sector in the financial system is wider than any alleged intrinsic merits of the cooperative model.

There is a useful perspective from the UK. Although technically Building Societies in the UK are not cooperative banks (not the least because, by regulation, they are not banks and do not offer the full range of banking services), as mutuals they are a sub-set of STV banks. It is instructive, therefore, to consider the case study of the UK where in 1986 the law was changed to allow mutual building societies to convert to SHV (Public Limited Company plc) bank status. As a result, in the second half of the 1990s, a powerful trend emerged towards de-mutualisation. Although the reserves of building societies were built up over several generations of members, on a de-mutualisation the current members had claim on the economic value of the mutual. In effect, members were compensated for surrendering the benefits of mutuality. In essence, de-mutualisation involved the appropriation of the mutuals intergenerational endowment by the current cohort of members. This represented an inter-generation transfer of benefits and wealth: to current members from the accumulation generated by past members and the benefits of potential future members. By 2008 all the converted building societies had lost their independent status either because they were purchased by other banks (e.g. Abbey National and Alliance and Leicester were purchased by Bank Santander) or because they failed and needed to be taken into public ownership (Northern Rock and, to some extent, Bradford and Bingley). The subsequent history of the de-mutualised building societies indicates that problems emerged on both sides of the balance sheet. Abbey National (the first of the Societies to convert) encountered problems because of its diversification on the assets side of the balance sheet, while Northern Rock and Bradford & Bingley failed because of diversification on the liabilities side as they became excessively dependent upon securitisation and wholesale funding. It is not to be expected that building societies would be immune from the enormity of the banking crisis: collateral damage was inevitable. Nevertheless, building societies have generally been less scathed by the financial crisis than have banks in general and demutualised building societies in particular. In fact, such converted building societies proved to be the most vulnerable as they moved too far away from their traditional model.

While many banks faced serious financial problems in the crisis and needed state injections of capital, only two medium-sized retail banks actually failed and they were both previous building societies that had de-mutualised partly in order to undertake business that was not feasible or allowed as a mutual but which proved in the end to be the origin of their downfall. A lot has been lost in the British financial system as a result of the large-scale demutualisation of building societies in terms of systemic diversity, a critical mass of mutuality in banking (and the benefits to competition that this brings), and the intrinsic merits of the mutual model in some areas of finance. ___________________________________ David Llewellyn is the Professor of Money and Banking at Loughborough University and the Vienna University of Economics and Business Administration, Visiting Professor at the CASS Business School (London), and Consultant Economist to ICAP plc (the worlds largest inter-dealer broker). He has previously worked as an economist with Unilever (Rotterdam), the UK Treasury (London) and the International Monetary Fund (Washington). For many years he was a member of the London Advisory Board of the Halifax Building Society, and also a Public Interest Director on the Board of the Personal Investment Authority (a predecessor of the Financial Services Authority). He is a coauthor of the recently-published Centre for European Policy Studies volume Investigating Diversity in the Banking Sector in Europe: Key Developments, Performance and Role of Cooperative Banks.