Does new capital compromise mutuality?

Adrian Coles, director-general of the BSA, explains how the newly created Profit Participating Deferred Shares work and describes the debate it has stirred up in the building society sector

In mid-June the Financial Services Authority announced a new form of core tier one capital for building societies, offering societies new opportunities to enhance or replenish their capital resources.

Profit Participating Deferred Shares (PPDS) carry no specified coupon; rather, they are remunerated by what is, in effect, a variable and fully discretionary dividend that is capped at a stated percentage of the issuing society’s profits.

Compared to PIBS - Permanent Interest Bearing Shares, another form of deferred shares, but which carry, generally speaking, a fixed interest rate - the new capital looks more affordable when profitability is low.

PPDS also have, it is suggested, more elaborate loss absorbency features compared with PIBS. The PPDS dividend is not only fully discretionary, but may be paid out only from current, distributable profits, not out of past earnings.

Where profits are made, but less than the stated percentage is paid out to the PPDS holders, the balance – up to the stated percentage – is allocated to a special PPBS reserve and is also used to absorb future losses.

PPDS also have a principal write down feature and the FSA states that these loss absorbency characteristics together mean, in the FSA’s view, that PPDS can qualify as core tier one capital to an unlimited extent.

The BSA and FSA currently disagree on the extent to which PIBS might qualify in this way, but the BSA sees no reason why the new form of capital should disturb the core tier one status of PIBS.

At the same time as the FSA announcement, the West Bromwich Building Society announced that it would be the first to use the new form of capital through a conversion of its subordinated debt – a tier two form of capital available to absorb losses only in the event that it was determined that a society is not a going concern.

The debate

The issuance of the new capital has provoked a healthy debate within the building society sector about the extent to which the traditional mutual model has been compromised by the new form of capital.

After all, up to 25 per cent of the profit of the society can now be allocated to PPDS holders; this group of investors share some characteristics of ordinary share investors in a plc.

Arguably, a society issuing such deferred shares now has to generate profits to meet the expectations of these investors, compromising the traditional ability of the society to concentrate solely on the needs of its members – its savers and borrowers.

Moreover, critics will suggest that members of a society intending to issue PPDS should have a vote on the proposal as it is argued it fundamentally changes the nature of the institution.

Those supporting the change point out that there are also substantial advantages for members of a society which is issuing PPDS. Firstly, the core tier one capital ratio of the institution is strengthened. This means that members’ funds are more secure and are backed by more loss-absorbing capital than was the case before the issue of the PPDS. In today’s febrile financial world, this is an important advantage.

Moreover, members concerned to have their democratic say on the decision of a society to issue PPDS can voice their views at the next annual general meeting of the society. In the case of the West Bromwich, this follows the announcement of the issuance of PPDS by only a few weeks.

In terms of cash flows, as Robert Sharpe pointed out the BBC Radio 4 programme, Moneybox, members are also better off in that in the short to medium term the payments to be made to the new PPDS holders are likely to be lower than the interest payments payable to those same people in their former guise as holders of subordinated debt.

Furthermore, each holder of PPDS has only one vote, as a member, irrespective of the value or number of PPDS held – a clear contrast with the plc sector, where institutions can buy voting power in the market.

Finally, it is notable that the West Bromwich announcement was made in the same week as the announcement of the disappearance from British high streets of all the branches of Abbey, Alliance & Leicester, Bradford & Bingley and Cheltenham & Gloucester banks – albeit that some of them will be retained under a different name.

One of the casualties of the current recession is consumer choice. Whatever the outcome of the debate on the appropriate forms of capital for building societies, the retention of as much consumer choice as possible in the new market conditions will be welcomed by many.

PPDS have been with us for only a few weeks and it’s too early to make a balanced, objective assessment of their potential impact – there are clearly pros and cons; we expect them to continue to provoke a lively debate in the sector over the coming months.

Adrian Coles is director-general of the Building Societies Association