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Co-Operative Bank (42RQ)

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Thursday 09 March, 2017

Co-Operative Bank

Annual Report and Accounts 2016

RNS Number : 9609Y
Co-Operative Bank PLC (The)
09 March 2017
 

The Co-operative Bank plc announces that the following document has today been submitted to the National Storage Mechanism and will shortly be available for inspection at www.morningstar.co.uk/uk/NSM:

 

 • Annual Report and Accounts 2016.

 

A copy of the Annual Report and Accounts 2016, Pillar III Report 2016 and an investor presentation are available within the Investor Relations section of our website www.co-operativebank.co.uk/investorrelations.

 

This announcement also contains additional information for the purposes of compliance with the Disclosure and Transparency Rules, including a consolidated set of financial statements, principal risks and uncertainties, details of related party transactions and a responsibility statement. This information is extracted, in full unedited text, from the Annual Report and Accounts 2016. Reference to pages and numbers refer to page numbers and notes to the 2016 Annual Report and Accounts and 2015 comparatives are as restated in those accounts.

 

Certain terms

The term the 'Bank' means The Co-operative Bank plc together with its consolidated subsidiaries. The term 'Company', refers to The Co-operative Bank plc. In this report the abbreviations '£m' represent millions of pounds sterling, and '£bn' represents billions of pounds sterling.

Unless otherwise stated, the income statement analyses and compares the 12 months to 31 December 2016 to the corresponding 12 months of 2015. The balance sheet comparisons relate to the corresponding position as at 31 December 2015. Unless otherwise stated, all disclosed figures relate to continuing operations. Relevant terms that are used in this document but are not defined under applicable regulatory guidance or International Financial Reporting Standards (IFRS) are explained in non-IFRS measures below.

 

Non-IFRS measures

Certain non-IFRS measures are provided within this report. These can be found mainly (but not exclusively) in the Detailed Financial Review and the Key Highlights page.

 

Forward-looking statements

This announcement, including information included or incorporated by reference in this announcement, contains certain forward looking statements with respect to the business, strategy and plans of the Bank (including its 2017-2021 Strategic Plan or the "Plan") and its current targets, goals and expectations relating to its future financial condition and performance, developments and/or prospects. In particular, the Strategic Update in this announcement includes forward-looking statements regarding a proposed additional CET1 capital raising, the Bank achieving CET1 ICG compliance from 2017 onwards and an anticipated £250 million Tier 2 debt issuance in 2018 and further MREL qualifying debt issuances in 2020/2021. By their nature, forward looking statements involve risk and uncertainty because they are based on current plans, estimates, targets, projections, views and assumptions and are subject to significant inherent risks, uncertainties and other factors both external and internal relating to the Bank's Plan, strategy or operations, which may result in the Bank being unable to achieve the current targets, predictions, expectations and other anticipated outcomes expressed or implied by these forward-looking statements. In addition, certain of these disclosures are dependent on choices relying on key model characteristics and assumptions and are subject to various limitations, including assumptions and estimates made by management. Accordingly, undue reliance should not be placed on forward-looking statements.

There are a large number of important factors which could adversely affect the Bank's operating results and financial condition, the Bank's ability to implement its Plan and cause the Bank to miss its targets or affect the accuracy of these forward-looking statements. These include risks and uncertainties summarised in the 'Principal Risks and Uncertainties' section of the Bank's Annual Report and Accounts for the Financial year ended December 2016, in particular the risks and uncertainties summarised under the sections titled  'Background and the Bank's Plan' and 'Anticipated Regulatory Capital Requirements'.

 

The Bank does not assume any obligation to, and do not intend to, revise or update these forward looking statements, except as required pursuant to applicable law.

 

No offer of securities

This announcement is not, nor should be construed as, an offer of, or solicitation of an offer to purchase or subscribe for, any securities to any person in any jurisdiction. In particular, this announcement does not constitute an offer for sale of, or a solicitation to purchase or subscribe for, any securities in the United States. No securities of the Bank have been, or will be, registered under the US Securities Act of 1933, as amended (the "Securities Act"), and securities of the Bank may not be offered or sold in the United States absent an exemption from, or in a transaction not subject to, the registration requirements of the Securities Act and in compliance with any applicable securities laws of any state or other jurisdiction of the United States.

 

The Co-operative Bank plc

9 March 2017

 

Annual Report and Accounts for the full year ended 31 December 2016

 

Key Highlights

 

Statutory loss before taxation, still impacted by legacy issues, has reduced to £477.1m in 2016 compared to a loss before tax of £610.6m in 2015

•  Adverse impacts include a reduction in net interest income, an increase in the fair value amortisation associated with the merger with the Britannia Building Society and higher remediation and strategic project costs.

•  Favourable impacts partially offsetting these adverse movements were: reduced operating costs, lower losses on asset sales, a gain recorded from the sale of the Visa Europe share and lower conduct charges.

•  Net interest income decreased by £76.7m to £394.8m (2015: £471.5m) as a result of lower Non-core asset balances, new business asset spreads remaining under pressure due to strong competition in the mortgage market and to a lesser extent, the impact of the reduction in the Bank of England base rate.

•  Conduct and legal risk charges reduced by £168.8m to £24.9m as the conduct remediation programme has substantially completed. The main driver of the charge in 2016 relates to £36.0m for PPI, which was partially offset by other provision releases.

•  Remediation and strategic project costs increased to £275.6m in 2016 (2015: £216.2m), reflecting the transformation required to address the historic under investment in systems and processes. This includes £81.9m expensed in connection with the mortgage outsourcing programme, of which £48.5m relates to assets no longer expected to be in use.

•  Fair value amortisation associated with the merger with the Britannia Building Society increased by £60.1m in 2016 to £180.5m (2015: £120.4m), representing 38% of the loss before taxation.

•  The Bank's Common Equity Tier 1 (CET1) ratio stood at 11.0% at 31 December 2016 (31 December 2015: 15.5%) reflecting a reduction in Risk Weighted Assets (RWAs) of £0.7bn and a statutory loss after tax of £418.7m.

 

Simplifying of the business and reducing underlying costs continues

•  Total operating costs reduced by £47.1m to £444.8m (2015: £491.9m), due to headcount reductions, further rationalisation of the branch network and lower third party costs.

•  Operating staff costs have decreased year on year by £30.3m to £187.7m (2015: £218.0m). FTEs (including contractors) have fallen by 809 from 4,704 to 3,895.

•  59 branch closures completed in 2016, reducing the network to 105 branches.

•  Successful migration of the Bank's core mainframe system to the new IBM managed environment completed in February 2017.

 

Rebuild of the retail franchise is gaining traction

•  Mortgage originations continued to increase with completions totalling £3.1bn in 2016 (2015: £2.8bn), whilst redemptions (excluding contractual repayments) fell to £1.7bn (2015: £2.3bn). Our intermediary channel Platform accounted for 91% of completions and was voted Intermediary Lender of the Year for the second year running at the Your Mortgage awards.

•  The Retail mortgage book grew by 5% to £14.1bn (2015: £13.4bn), representing 1.1% market share.

•  Following the launch of our new Everyday Rewards current account, the number of prime current account holders increased by 8,303 to 664,268 (2015: 655,965).

•  Customer relationship metrics across the Bank remain strong. The Bank's current account Net Promoter Score (NPS) was 17 at the end of 2016. The Bank ranked #4 in current account NPS which emphasises the strong service levels being delivered in contact centres and branches alongside continued improvement in digital channels and customer satisfaction ratings. The Bank has moved back into the Top 50 brands for customer service, climbing 46 places from 2015.

•  New and improved online banking platform launched in May 2016.

•  An upgraded mobile app was released in September 2016 and Apple Pay was launched in October 2016.

 

Continue building differentiated proposition on the expanded Ethical Policy

•  New rewards based current account proposition, Everyday Rewards launched in January 2016.

•  Return to campaigning, in partnership with Refuge, a leading UK domestic abuse charity launched the 'My money, my life' campaign to raise awareness and support of financial abuse.

 

Focus for 2017

•  Successfully manage the potential sale process and Liability Management Exercise/capital raise, announced on 13 February 2017.

•  Continue to focus on costs.

•  Continue to ensure the Risk Management Framework is fully embedded across the Bank and progress IRB models remediation.

•  Continue investment in the brand and development of products and services which reflect the Bank's customer-led Ethical Policy.

•  Continue to focus on quality of service.

 

Strategic Update

•  The Bank's announcement on 26 January 2017 noted that the Bank expected its CET1 ratio (in the absence of any management actions) to fall and remain below 10% over the medium term and that it was unlikely to meet its Individual Capital Guidance (ICG) over the planning period to 2020. In addition, the Bank reported that it continued to expect to meet its Pillar 1 capital requirements and to maintain sufficient liquidity to meet its obligations.

•  The Bank's announcement on 13 February 2017 noted that the Bank has always been clear that, although it met Pillar 1 regulatory capital requirements and expected to continue to do so, it needed to build its capital and meet longer term UK bank regulatory capital requirements. This announcement continued by noting that its capacity to do so organically had been constrained by (i) the impact of interest rates that are lower than previously forecast, reducing the Bank's ability to generate income, and (ii) higher than anticipated transformation and conduct remediation costs. The announcement also noted that the Bank has also needed to consider enhanced regulatory capital and MREL requirements expected of all UK banks.

•  As a result, and having concluded its annual planning review, the Bank announced the commencement of a sale process, inviting offers for all of its issued ordinary share capital, and that it was considering ways of raising equity capital from existing and new capital providers and a potential liability management exercise of its outstanding public debt.

•  As an alternative to a sale, the Bank's Plan seeks to raise an additional £700m to £750m of CET1 resources. Whilst the structure, terms and timing are to be finalised, this may be achieved via a liability management exercise involving the potential exchange of the Bank's debt securities to equity (taking into account the Bank's creditor hierarchy) alongside an additional primary equity capital raise of approximately £300m to enable the Bank to achieve CET1 ICG compliance from 2017 onwards. Furthermore, assuming the successful completion of such capital raise, the Bank is anticipating circa £250m Tier 2 issuance during 2018 and further MREL qualifying debt issuances in 2020/21. If all of these measures are implemented as planned, the Bank expects to be fully ICG compliant from 2018 and meet all capital and interim MREL requirements in 2019.

 

Liam Coleman, Chief Executive Officer, said:

 

"In 2016, we continued to deliver significant progress against our turnaround plan rebuilding a customer focused retail bank with strong levels of new mortgage business, growing current account numbers and a distinctive ethical brand; but at the same time we faced a number of challenges. The historically low interest rate environment, legacy issues and the cost of the scale of transformation required continued to impact on the performance of the business. Today's results reflect those factors, which led to the Board's decision to commence a sale process and to look at other options of building capital, and they also demonstrate there is clear potential to build our unique franchise in the future.

 

"Since 2013 considerable progress has been made fixing the problems of the past and the Bank is now in a very different position than it was in 2013 and stronger in many areas. Many of the remediation projects have now largely been completed and we have reached a number of key transformation milestones this year. In particular, the fact we have successfully migrated our key systems to IBM and now meet the regulator's threshold conditions for IT, highlights how much has been done to build the Bank's resilience in this area. Importantly, 2017 marks the year when the fair value amortisation related to the merger with the Britannia Building Society in 2009 comes to a close and when we expect project costs to decline. 

 

"The announcement of a sale and consideration of other options to build capital is therefore about how the Bank sees through the next stage of its turnaround plan. Obviously, we are only a few weeks into the sale process but we are pleased with the interest to date and engaging with potential bidders as planned.

 

"This is a great retail bank and one that is valued by our 4 million loyal customers. We believe there is opportunity and potential to build on the progress made and on our distinctive ethical position."

 

Investor Call

 

An investor call will be held as follows:

Date: Thursday 9 March 2017

Time: 9.30 am

Dial: +44 (0) 20 3059 8125

A webcast will also be available at www.co-operativebank.co.uk/investorrelations  

 

An operator will assist you in joining the call.

 

Investor enquiries:

Jonathan Berger, Head of Investor Relations: +44 (0) 7595 567 502

 

Media enquiries:

Lesley McPherson, Director of Communications: +44 (0) 7725 903 270

David Masters, Lansons: +44 (0) 7825 427 514

Tony Langham, Lansons: +44 (0) 7979 692 287

 

About The Co-operative Bank

The Co-operative Bank plc provides a full range of banking products and services to almost 4 million retail and small and medium sized enterprises customers. The Bank is committed to values and ethics in line with the principles of the co-operative movement. The Co-operative Bank plc is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The Co-operative Bank plc customers are protected by the Financial Services Compensation Scheme in the UK.

 

Key Performance Indicators

The Key Performance Indicators presented below1 reflect the way in which the performance of the Bank was measured in 2016. As the Bank continues to implement its turnaround, management will continue to review these measures.


2016

2015

Change

Notes

Total Bank





Statutory (loss) before tax (£m)

(477.1)

(610.6)

133.5

The Bank's loss before tax in 2016 continued to be impacted by legacy issues. Adverse impacts include the reduction in net interest income, an increase in the fair value amortisation associated with the merger with the Britannia Building Society and higher remediation and strategic project costs. Favourable impacts partially offsetting this are: reduced operating costs, lower losses on asset sales, a gain recorded from the sale of the Visa Europe share and lower conduct charges.

Net interest margin2 (%)

1.39

1.42

(0.03)

Small decrease in net interest margin impacted by competitive pressures on new asset margins and the reduction in Bank of England base rate.

Cost:income ratio3 (%)

103.7

100.0

3.7

Cost:income ratio increased as reductions in operating expenditure and operational project expenditure were more than offset by the reduction in interest income.

Common Equity Tier 1 (CET1) ratio (%)

11.0

15.5

(4.5)

CET1 ratio has decreased primarily as a result of the statutory loss after tax.

Leverage ratio (%)

2.6

3.8

(1.2)

Statutory losses have reduced Tier 1 capital at a greater rate than the balance sheet has been deleveraged.

Total RWAs (£bn)

6.7

7.4

(0.7)

Total RWAs have reduced in line with Non-core deleverage partially offset by growth in Core customer assets.

Total capital (%)

17.7

21.6

(3.9)

Total capital ratio has decreased reflecting the reduction in CET1 capital.

Colleague engagement (%)

64.0

66.0

(2.0)

Colleague engagement remains broadly stable as we continue our cultural change programme.

Core Bank





Customer deposits(£bn)

22.1

22.4

(0.3)

Retail and BaCB deposits.

Customer assets (£bn)

15.3

14.7

0.6


Credit RWAs (£bn)

3.9

3.7

0.2


Total Current Account Holders

1,435,470

1,431,323

4,147


Prime Current Account Holders

664,268

655,965

8,303


Net interest margin2 (%)

1.78

1.89

(0.11)


Non-core Bank





Customer assets (£bn)

4.1

4.9

(0.8)


Credit RWAs (£bn)

2.0

2.8

(0.8)


1. KPIs are calculated on a management accounts basis as this is how we manage our business.

2. Net interest margin is calculated as net interest income divided by the average of the opening and closing asset balances for the period.

3. Operating expenditure and operational projects (including associated depreciation and amortisation) divided by operating income excluding losses on assets sales.

 

Please see 'Detailed Key Performance Indicators' on page 32 for explanations of why these metrics are important and how they are calculated.

 

Bank Performance - Key Highlights and Outlook

Statutory loss before taxation, still impacted by legacy issues, has reduced to £477.1m in 2016 compared to a loss before tax of £610.6m in 2015

•  Adverse impacts include a reduction in net interest income, an increase in the fair value amortisation associated with the merger with the Britannia Building Society and higher remediation and strategic project costs.

 

•  Favourable impacts partially offsetting these adverse movements were: reduced operating costs, lower losses on asset sales, a gain recorded from the sale of the Visa Europe share and lower conduct charges.

 

•  Net interest income decreased by £76.7m to £394.8m (2015: £471.5m) as a result of lower Non-core asset balances, new business asset spreads remaining under pressure due to strong competition in the mortgage market and to a lesser extent, the impact of the reduction in the Bank of England base rate.

 

•  Conduct and legal risk charges reduced by £168.8m to £24.9m as the conduct remediation programme has substantially completed. The main driver of the charge in 2016 relates to £36.0m for PPI, which was partially offset by other provision releases.

 

•  Remediation and strategic project costs increased to £275.6m in 2016 (2015: £216.2m), reflecting the transformation required to address the historic under investment in systems and processes. This includes £81.9m expensed in connection with the mortgage outsourcing programme, of which £48.5m relates to assets no longer expected to be in use.

 

•  Fair value amortisation associated with the merger with the Britannia Building Society increased by £60.1m in 2016 to £180.5m (2015: £120.4m), representing 38% of the loss before taxation.

 

•  The Bank's Common Equity Tier 1 (CET1) ratio stood at 11.0% at 31 December 2016 (31 December 2015: 15.5%) reflecting a reduction in Risk Weighted Assets (RWAs) of £0.7bn and a statutory loss after tax of £418.7m.

 

Simplifying of the business and reducing underlying costs continues

•  Total operating costs reduced by £47.1m to £444.8m (2015: £491.9m), due to headcount reductions, further rationalisation of the branch network and lower third party costs.

 

•  Operating staff costs have decreased year on year by £30.3m to £187.7m (2015: £218.0m). FTEs (including contractors) have fallen by 809 from 4,704 to 3,895.

 

•  59 branch closures completed in 2016, reducing the network to 105 branches.

 

•  Successful migration of the Bank's core mainframe system to the new IBM managed environment completed in February 2017.

Rebuild of the retail franchise is gaining traction

•  Mortgage originations continued to increase with completions totalling £3.1bn in 2016 (2015: £2.8bn), whilst redemptions (excluding contractual repayments) fell to £1.7bn (2015: £2.3bn). Our intermediary channel Platform accounted for 91% of completions and was voted Intermediary Lender of the Year for the second year running at the Your Mortgage awards.

 

•  The Retail mortgage book grew by 5% to £14.1bn (2015: £13.4bn), representing 1.1% market share.

 

•  Following the launch of our new Everyday Rewards current account, the number of prime current account holders increased by 8,303 to 664,268 (2015: 655,965).

 

•  Customer relationship metrics across the Bank remain strong. The Bank's current account Net Promoter Score (NPS) was 17 at the end of 2016. The Bank ranked #4 in current account NPS which emphasises the strong service levels being delivered in contact centres and branches alongside continued improvement in digital channels and customer satisfaction ratings. The Bank has moved back into the Top 50 brands for customer service, climbing 46 places from 2015.

 

•  New and improved online banking platform launched in May 2016.

 

•  An upgraded mobile app was released in September 2016 and Apple Pay was launched in October 2016.

Continue building differentiated proposition on the expanded Ethical Policy

New rewards based current account proposition, Everyday Rewards launched in January 2016.

 

Return to campaigning, in partnership with Refuge, a leading UK domestic abuse charity launched the 'My money, my life' campaign to raise awareness and support of financial abuse.

 

Focus for 2017

•  Successfully manage the potential sale process and Liability Management Exercise/capital raise, announced on 13 February 2017.

 

•  Continue to focus on costs.

 

•  Continue to ensure the Risk Management Framework is fully embedded across the Bank and progress IRB models remediation.

 

•  Continue investment in the brand and development of products and services which reflect the Bank's customer-led Ethical Policy.

 

•  Continue to focus on quality of service.

 

Chairman's statement

2016 was a year of both progress and challenge for The Co-operative Bank, culminating in the Board's decision announced on 13 February 2017 to commence a sale process and consider other options to build capital.

 

The Board has only been able to consider these options as a result of the considerable progress that has been made in delivering the Bank's turnaround plan over the last three years. The Bank is stronger in many areas than in 2013 and these options would simply not have been feasible before.

 

Since 2013, a viable Core Bank has been rebuilt, non-core assets have been reduced by more than half, legacy conduct issues have been substantially remediated, and risk management disciplines have been improved. We have resolved significant IT weaknesses with the successful migration of our key IT applications to an outsourced arrangement with IBM, resulting in the FCA confirming that we are no longer in breach of their Threshold Conditions for IT. Most importantly, we have a robust franchise anchored in our Values and Ethics which are clearly important to our customers and colleagues.

 

During 2016 we delivered further positive progress in rebuilding a customer-focused retail banking proposition with values and ethics at its heart; a proposition that we believe has the potential to grow further in the future. We also reached several key milestones in our turnaround plan, notably in separating our IT systems from The Co-operative Group, which will continue throughout 2017 and beyond, and in further embedding risk management, ensuring better customer outcomes.


At the same time, challenges emerged that impacted on our plan. A key factor has been the lower for longer interest rate environment which has affected the income and profitability profile of the Bank. In addition, the costs of transforming the Bank and fixing the legacy issues of the past, proved to be higher than we originally anticipated. These factors combined have constrained the Bank's ability to build capital in the medium term, and contributed to the Board decision and announcement of 13 February 2017. Further information is provided in the Outlook section of the Detailed Financial Review section of this report.

 

A key priority for the Board in 2016 was to achieve an orderly executive succession in the key roles of Chief Executive Officer (CEO) and Chief Financial Officer (CFO), and to ensure the smooth transition to the new Executive team to lead the Bank into the next phase of its turnaround. I was delighted to confirm the appointment of Liam Coleman as CEO of the Bank from 1 January 2017, succeeding Niall Booker, and to welcome John Worth to the Bank as CFO in October 2016, taking over from John Baines. I would like to express my thanks to Niall Booker and John Baines for their successful stabilisation of the Bank, which was achieved without cost to the British taxpayer. I look forward to working with Liam, John and the executive team as we take the Bank forward in 2017.

 

There was also change in our Non-Executive Directors with Graeme Hardie and Richard Coates stepping down from the Board during the year. In October 2016 we welcomed Glyn Smith onto the Board as an Independent Non-Executive Director along with Alistair Asher, who was nominated by The Co-operative Group as a Non Independent Non-Executive Director under the terms of the Relationship Agreement and joined the Board in September 2016. I would like to thank our Non-Executive Directors for their work and contribution during their respective terms.

 

On behalf of the Board, I would like to thank colleagues for their continuing commitment to our customers and our business, our customers for their continued loyalty and our investors for their continued support.


Dennis Holt
Chairman

08 March 2017

Our business areas

During 2016, the Core and Non-core business areas were managed as set out below to align with the Bank's plan to rebuild resilience, de-risk and reshape its balance sheet and to address the underlying issues it faces.

 

 

Core

Non-core

Definition

•  Consistent with the Bank's strategy and risk appetite

 

Includes:

Retail Banking (Retail) - which trades as The Co-operative Bank, Britannia and smile, together with the Bank's intermediary mortgage brand, Platform, and includes Retail secured and unsecured lending

 

Business and Commercial Banking (BaCB) - focused on offering simple solutions to meet the needs of small business (SME) customers mainly focused around savings and current accounts. We continue to service our existing complex customers with a range of corporate banking facilities but it is small business where we are seeking to develop customers and deposits, in particular those in the Charity and Co-operative sectors

 

Treasury and Other

 

•  Inconsistent with the Core business strategy and risk appetite

•  Cannot be supported by Core business IT Retail platform

•  Non-core assets are typically but not exclusively non-performing, defaulted, unprofitable and/or capital intensive products

 

Legacy Portfolio includes:

•  Corporates - which typically have a turnover of over £25m or otherwise do not meet the Bank's risk appetite

•  Commercial Real Estate

•  Project Finance2

•  Housing Associations

•  Local Authorities

•  Large scale Renewable Energy and Asset Finance2

 

Optimum (a closed book of predominantly interest-only, intermediary and acquired mortgage book assets)

 

Unity Trust Bank1 (UTB) - Reduced shareholding

Focus

•  Retail and SME customers

•  Values and ethics that both underpin our business and distinguish us in the marketplace

•  Relationship-based banking

•  Where we have strong market credentials, relationships and expertise

•  Investment into digital channels

•  Offering customers products that are easy to understand and use

•  Managing these businesses to achieve deleverage that does not materially reduce the CET1 ratio of the Bank as a whole

1.  UTB operates in the social economy and commercial banking sectors and was previously consolidated into the Bank's results on the basis of control. As of December 2015, the Bank's residual holding of Unity Trust Bank's shares reduced to 6.7%. This is treated as Non-core business.

2.  Transferred to BaCB within Core in February 2016, transferred back to Non-Core in December 2016.

 

As of 1 January 2017, the Core and Non-core business split will no longer apply. This is in recognition of the need for the Bank to work as one business, with this one business structured into five Business Units. The construction of Business Units remains unchanged from the descriptions above and a summary of each as at 31 December 2016 is below.

 

Definition

Retail Banking

BaCB

Optimum

Legacy Portfolio

Treasury and Other

Managed Assets

£14.8bn

£0.4bn

£2.8bn

£1.5bn

£7.9bn

Managed Liabilities

£19.4bn

£2.7bn

-

£0.1bn

£4.0bn

Credit

RWAs

£1.9bn

£0.5bn

£0.9bn

£1.1bn

£1.5bn

Operating

Income

£372.8m

£63.3m

(£15.7m)

(£6.7m)

£34.3m

 

Our strategy and business model

The Bank is focused on implementing its strategy of becoming a smaller, sustainable and efficient bank, distinguished by its values and ethics, that is focused on retail and SME customers.

 

 

Bank Vision

 

 

To become an efficient and financially sustainable UK Retail and SME Bank that is distinguished by its values and ethics

 

 

Overarching Strategy

 

Offer a differentiated proposition, serving a loyal customer base

Serving Retail and SME customers with propositions differentiated through values & ethics, brand and customer service excellence

Offer a choice of distribution channels

Offering distribution channels and services aligned to customer demand

Offer a customer-centric product range

Offering simple, clear, fair and transparent products to meet customer needs

Deliver a right sized operating cost base

Focus on reducing costs within a challenging macro environment

Underpinned by capital resilience and regulatory compliance

 

Key Activities and Actions

 

 

Retail and SME business strategy

Simplify and focus on Retail and SME customers

•  Enhance returns

•  Improve cost:income ratio

•  Build on existing foundations and capabilities

 

 

Legacy Portfolio and Optimum business strategy

Actively manage to achieve the most appropriate value for each portfolio or target for run down to exit

•  Taking into consideration liquidity and capital requirements

 

Key actions for the Retail and SME businesses:

•  Streamline Retail and SME product offerings

•  Focus on existing customer base and acquisition of 'prime' customers

•  Communicate our 'difference' as experienced by customers, colleagues and communities

•  Re-price to market/exit uneconomic products

•  Consistently deliver first class customer service across every interaction

 

 

Key actions for the Legacy Portfolio and Optimum businesses:

•  Active management of assets

•  Single asset and portfolio sales

•  Optimisation of borrowers' funding structures

•  Re-banking of Non-core customers

•  Run down or close business over the longer term

 

Key actions for the Bank as one business:

 

•  Ensure our values and ethics are at the heart of everything we do and inform the decisions we make

•  Reduce costs and simplify business processes

•  Establish and embed an effective and efficient operational and governance structure

•  Continue to embed the Risk Management Framework and strengthen our culture

•  Manage reputational and conduct risk

•  Energise and empower all colleagues to perform at their best

 

 

How we make money

The table below summarises the business activities performed by the Bank and the associated impact across the balance sheet, income statement and risk.

 

Business Activity

Balance Sheet Impact

Income Statement Impact

Principal Risks

We lend money to customers

Loans create assets in our balance sheet that will generate future income

We earn interest income, fees and may incur credit impairment charges

Credit risk

Market risk

Operational risk

Liquidity and funding risk

Conduct risk

We collect deposits from customers

Deposits are a source of funding for the Bank (liabilities) which often incur interest expense

We may pay interest on deposits

Liquidity and funding risk

Market risk

Operational risk

Conduct risk

We source funding from other banks and the capital markets

Wholesale funding is a liability for the Bank on which we incur interest expense

We pay interest on wholesale funding

Liquidity and funding risk

Market risk

Operational risk

We provide transactional banking facilities

Minimal

We earn net fee and commission revenue

Operational risk

Conduct risk

We invest in people in order to implement our strategy and deliver service to our customers

Minimal

Staff costs

Operational risk

Conduct risk

People risk

Pension risk

We invest in our operations (IT and infrastructure) to deliver service to our customers while managing costs

Property, plant and equipment, Intangible assets

Other operating costs

Operational risk

Strategic and business risk

 

Chief Executive's review 2016

Overview

In 2016, The Co-operative Bank continued to deliver progress against its turnaround plan, while at the same time facing a number of challenges. Building capital has always been part of our long term plans. However, our ability to do so organically has been constrained by a number of factors. As outlined by the Chairman, these factors together led to the Board's decision to commence a sale process and also consider other options to build capital, announced on 13 February 2017.

 

It is important to highlight that the Bank is stronger in many areas than in 2013. In 2016 our achievements reflected a number of significant steps forward as the Bank continued to address the legacy issues of the past, while building a renewed, digitally-enabled retail bank for the future, differentiated by its distinctive ethical brand and strong customer service.

 

The announcement of a sale and consideration of other options to build capital is therefore about how the Bank sees through the next stage of its turnaround plan, recognising there is considerable potential in the Bank given the strength of the brand, its reputation for strong customer service and distinctive position based on its Values and Ethics.

 

Progress since 2013

In 2013, our strategy was to stabilise the Bank and to reshape the business around our retail and SME customers and this is what we have done. A customer focused retail bank is emerging with an award-winning mortgage platform, a growing prime current account base and continued recognition for the service colleagues provide. We have continued to invest in our brand, maintained high customer satisfaction and invested in our digital services, whilst working to make the Bank fit for the future in terms of its cost base, infrastructure and risk management processes.

 

In terms of highlights, progress includes:

 

•  High levels of customer satisfaction have been maintained, evidenced by Net Promoter Scores (NPS) that are consistently in the top four in the UK retail banking market;

 

•  A new current account proposition, Everyday Rewards, was successfully launched in 2016, which contributed to a net increase in overall and prime current account customers;

 

•  Continued investment in a differentiated brand through renewed TV advertising and campaigning and being recognised as the most improved brand by YouGov;

 

•  Successfully built on the refreshed Ethical Policy relaunched in 2015 which sought greater involvement from customers as well as non-profit organisations. Customer research indicates the Bank is perceived as the UK's most ethical banking brand, and one of the most trusted;

 

•  Significantly de-risked balance sheet with over half of the original Non-core portfolio sold in an orderly manner since 2013;

 

•  The cost base has reduced by over 20% since 2014 and the ongoing cost reduction programme is intended to deliver further savings over the next 12 months;

 

•  A comprehensive remediation programme has identified and substantially addressed a broad range of historic conduct issues;

 

•  A successful digital transformation has been delivered and all current account customers who use online banking have been migrated to the new digital platform; and

 

•  Overall IT resilience and stability has improved substantially since 2013, with stronger end-to-end disaster recovery capability. In a two year effort culminating over the weekend of 11 and 12 February 2017, the Bank migrated its core mainframe system and associated mid-range servers to IBM-managed data centres. The first half of 2017 will see us migrate a number of non-customer facing systems as the programme moves towards completion.

 

2016 progress rebuilding a viable Retail and SME bank

In 2016 we began to see the tangible results of our turnaround plan. New product development, digital transformation and brand marketing have all contributed to the re-establishment of an attractive proposition. Profitability was impacted in the second half of the year following the reduction in the base rate. However management action has focused on cost reduction and other measures designed to address this. Current account performance remained strong as prime current accounts increased by 8,303 and current account balances increased from £3,801.5m at the end of 2015 to £4,229.2m at the end of 2016. Our new current account proposition, Everyday Rewards, was launched in the first quarter of 2016. The product features the opportunity for customers to earn monthly cash rewards in return for responsible day to day usage of their account. Customers also have the option to donate their rewards to one of five charity partners. The launch was supported by a £150 switching incentive campaign which ran during times of the year where customers are most likely to switch, and was consistently one of the leading incentives on offer in the market. This new proposition has delivered a significant increase in customers joining the Bank and an eight-fold increase in customers using the Current Account Switch Service. This in turn has driven increasing numbers of customers opting into Everyday Rewards and growth in the volume of prime customers as a result.

At the same time, our digital programme continued to deliver planned improvements during 2016, and we are delighted that all current account customers now have the opportunity to benefit from our improved mobile banking app, and the availability of Apple Pay which we launched in October 2016.

 

Mortgage performance remained strong, driven primarily by our intermediary Platform operation, which was voted Intermediary Lender of the Year for the second year running at the Your Mortgage awards. Completions and redemptions for the year totalled £3.1bn and £1.7bn respectively compared to £2.8bn and £2.3bn in 2015.

 

During 2016 we focused on refreshing and rebuilding our ethical brand with renewed brand advertising, including a new TV advertising campaign and strapline 'It's good to be different' which highlights our ethical brand difference. Our research shows that we are consistently considered the most ethical banking brand by customers and non-customers, and with research highlighting that 37% of people would consider switching to an ethical bank, we plan to reinforce our ethical brand throughout 2017 to further distinguish our position in the market.

 

Our customer service credentials continue to set us apart from our competitors, with Net Promoter Scores (NPS) that are consistently in the top four of all UK banks. Our progress in this area is evidenced by the Institute of Customer Service recognising the Bank as the most improved banking brand and ranking us as a top 50 organisation for customer service. Our Financial Support Team also won Team of the Year at the CCA Excellence Awards, following the creation of a unique partnership with Citizens Advice Manchester to help customers in financial difficulty. It is heartening that others recognise our focus on excellent customer service and this is a key part of our customer proposition which we will seek to preserve.

 

During the course of 2016, we successfully integrated our Business and Commercial Banking operation into our retail business, reflecting our strategy to simplify our business and to streamline processes to better serve our SME customers. We also rationalised our SME product offering which made us easier to do business with and we have increased our focus on small enterprises. We have also recently enhanced the functionality of our online channel, which is indicative of our focus on improving the overall customer experience.

 

Overall Bank performance

Though legacy issues continued to impact on the overall financial performance of the business the statutory loss before taxation for 2016 narrowed to £477.1m compared to £610.6m in 2015. More information on the main drivers of the loss and the Bank's financial performance is included in the Detailed Financial Review, but in summary the results reflect the continued progress against the areas of focus outlined in the Bank's Strategic Plan, set against the 2016 interest rate cut, the ongoing low interest rate environment and the investment required to tackle the scale of the required transformation and legacy issues.

 

Remediation and strategic project costs remained high in 2016, reflecting investment in systems and processes. We do not anticipate similar levels of spend in 2017, as many of the transformation and remediation projects have now largely been completed. Additional one-off costs were also incurred as the Bank resolved all aspects of its existing contractual dispute and agreed revised terms relating to provision of mortgage administration services with Capita and the write off of associated transformation spend.


Capital

As previously stated, the lower for longer interest rate environment has impacted our plan and as a result our capital position. In January 2017 we provided an update to previous guidance that we now expect our CET1 ratio to fall and remain below 10% over the medium term, and that we will now no longer meet our ICG over the planning period to 2020. Further guidance is included in the Detailed Financial Review. The Bank continues to expect to meet its Pillar 1 regulatory capital requirements and to maintain sufficient liquidity to meet its obligations. The Board's decision to commence a sale process and consider additional options to build capital reflects the fact that due to the factors outlined earlier, the Bank is constrained in its ability to build its capital position organically.


Costs

We renewed our focus on our cost base in 2016, resulting in a reduction of £47.1m compared to 2015 with further management action planned for 2017. Operating costs fell 10% to £444.8m compared with £491.9m in 2015, driven by continued reduction of staffing levels, the impact of digital development and related branch rationalisation. Our branch network remains an important part of our multi-channel service and we continue to review customer behaviour as the declining trend in branch footfall continues. The 54 branch closures announced in January 2016 were completed by the end of June 2016, with a further 5 closed towards the end of the year. A programme of investment continues to improve our brand presence in core branches and we have recently moved to new premises in Manchester, Liverpool and in the near future, Sheffield. We are also planning to close an additional 10 branches by the end of 2017. This will result in a network of 95 branches, well placed across the UK. In addition, all Co-operative Bank customers can make everyday banking transactions via the Post Office's network of over 11,500 access points across the UK; around 6 million customer transactions were carried out via the Post Office network in 2016.


Values and Ethics

Our Values and Ethics, captured within our customer-led Ethical Policy are central to the way we operate as a Bank, and this sets us apart from our competitors. Our four million customers want an ethical approach to banking. 85% of our customers tell us our ethical credentials are one of the main reasons they choose to bank with us and our colleagues say this is a key reason why they want to work with us. 2017 will mark 25 years since our Ethical Policy was launched and over the past 25 years, over 320,000 customers have helped shape the policy.

 

We reached a milestone in 2016 where our customers have now donated over £5.0m to Oxfam over the course of a 20 year relationship between Oxfam and the Bank. In 2016 customer donations to our charity partners including the donations from our new Everyday Reward current account reached almost £880,000.

Our sponsorship for The Hive, which promotes the development of co-operative businesses, continued during 2016 with valuable support provided to new start up co-operative businesses. Our campaign in partnership with Refuge was successful in putting the issue of financial abuse in personal relationships firmly on the industry agenda, achieving a commitment to change industry practice, and this was recognised with a number of third sector awards. Our pioneering work on a pilot with Citizens Advice Manchester is making a tangible difference to vulnerable customers. We are extremely proud of our achievements in this area.

 

People and Culture

As the Chairman has said, Executive succession was a key priority during 2016. In addition to my appointment as CEO, John Worth joined the Bank as Chief Financial Officer in October 2016 replacing John Baines and Steven Pickering was appointed Chief Risk Officer effective from 8 August 2016. Tracey Kneller was appointed to the role of Human Resources Director at the end of 2016, and Heather Lauder, Matthew Carter and Ashley Lillie joined the Executive Committee as Director of Retail and Business Banking, Director of Products and Communications and Treasurer respectively. I am looking forward to working with them and with the wider Executive team as we continue to deliver our plan in 2017.

 

A number of colleagues left the Bank in 2016 as part of cost reduction initiatives. As a necessary step to support the Bank in achieving its cost cutting and rationalisation targets, it is nonetheless regrettable. I would like to thank colleagues for their continued professionalism and customer focus during the year.

 

We have also seen good progress in improving the culture of the Bank. Our focus on culture in 2016 saw colleagues attending 'Making the Difference' workshops where we looked at the desired and emerging culture of the Bank, focused on risk management, our customers, cost effectiveness and efficiency and our Values and Ethics. Our focus on the cost effectiveness of the Bank includes continuing to improve the working environment for our colleagues. We have modernised and refreshed our Skelmersdale site and similar initiatives are underway across our major occupancies.

 

We were proud to be among the first banks to sign up to the Government's Women in Finance initiative in September 2016, setting a target of 40% of women in senior management roles by 2020.


Resilience and risk management

Ensuring a more resilient Bank is a key objective and our renewal and outsourcing of the Bank's IT infrastructure management is central to this objective. Within our Enterprise Services outsourcing programme we completed the successful move of the first set of systems to the new IBM data centres in April 2016. This allowed us to bed down the new data centres and the new IBM managed service ahead of the major migration of the Bank's core systems, including the mainframe. During a weekend in February 2017 the Bank migrated its core banking operations into the new IBM-managed data centres. This marks a major milestone in the orderly separation and migration of core IT systems from The Co-operative Group to the outsourced managed service with IBM. The Bank has received confirmation from the FCA that they consider the breach of Threshold Conditions has been successfully remediated and the Bank to now be compliant with Threshold Conditions. This puts us in a great position to complete the Enterprise Services project in the first half of 2017, although ongoing separation of activity of residual IT service shared with The Co-operative Group will continue beyond 2017.

 

During 2016 we continued the embedding of our Risk Management Framework in the Bank, which reinforced knowledge and understanding, risk leadership and improved risk reporting and governance. This included a comprehensive programme of risk training and awareness delivered to all colleagues which re-emphasised the key message that managing risk is something that all colleagues need to do as part of their everyday activity. This is a critical part of our ongoing work to further improve the culture of the Bank, and is an area where we have made good progress.

 

Summary

While we continued to deliver in key areas of the plan in 2016, the combined impact of lower for longer interest rates and the higher than anticipated cost of transforming the Bank and addressing legacy issues mean that we are now more limited in our ability to build capital organically. This is reflected in the Board's decision to commence a formal sale process and consider other options to build capital for the future; this decision is in the best interests of all our stakeholders and the right route forward at this stage in the turnaround. This process is currently underway and, in the meantime, we continue to focus on what we do best - delivering an ethical banking proposition for our customers.

 

We believe there is value in our distinct position in the market and that the relationship we have with customers, centred on our values and ethics, distinguishes us and remains a key reason why four million customers choose to bank with The Co-operative Bank. The Board and the management team believe there is strong potential to build the franchise, using the strength of our brand, our reputation for strong customer service and our distinct values and ethics. In a market where there is little to distinguish many banking brands, we believe this continues to set us apart.

 

Liam Coleman

Chief Executive Officer

Detailed financial review

 

Capital

In 2016 the Bank's capital ratios have deteriorated owing to the continued losses which have eroded capital resources. These have not been offset by similar levels of RWAs reduction seen in prior periods primarily as a result of a lower rate of deleverage of Non-core assets.

 

All figures quoted below are reporting on a Capital Requirements Directive (CRD IV) basis.

 

The Bank's Common Equity Tier 1 (CET1) capital resources have decreased by £0.4bn in the period to £0.7bn, primarily as a result of the £418.7m statutory loss after tax for the year.

 

Core Credit Risk RWAs have increased to £3.9bn (2015: £3.7bn), driven by increased lending within the Retail secured portfolio. Operational Risk RWAs have decreased by £0.2bn following the annual recalculation of the Pillar 1 Operational Risk requirement subsequent to the 2015 year end results.

 

Non-core RWAs have reduced from £2.8bn to £2.0bn, driven by the continued deleverage of the Legacy Portfolio and natural run off within Optimum.

 

The movements outlined above are the primary factors resulting in the Bank's CRD IV CET1 ratio decreasing by 4.5% from 15.5% to 11.0%.

 

The Bank continues to hold a £0.3bn temporary RWA adjustment within the Optimum RWAs (2015: £0.3bn) due to historic deficiencies relating to the Bank's secured Loss Given Default (LGD) and Probability of Default (PD) models. Having conducted further analysis, the Bank now intends to remove the remaining £0.3bn temporary adjustments in March 2017.

 

The Bank's total capital ratio stands at 17.7% as at 31 December 2016 (2015: 21.6%) relative to the Pillar 1 regulatory minimum of 8%.

 

The Bank's leverage ratio is 2.6%, down 1.2% from 2015, reflecting the reduction in CET1 capital driven by the statutory loss in the year. The Bank is not currently subject to the 3% minimum requirement as it has retail deposit levels below £50bn, the threshold at which it becomes a binding requirement.

 

CRD IV capital position


2016

2015

Change

CET1 Resources post Regulatory adjustments (£m)

736.9

1,151,1

(414.2)

RWAs (£m)

6,676.1

7,422.9

(746.8)

CET1 ratio

11.0%

15.5%

(4.5%)

Total capital

17.7%

21.6%

(3.9%)

Leverage ratio

2.6%

3.8%

(1.2%)

 

Regulatory requirements

As at 31 December 2016, the Bank did not meet its Individual Capital Guidance (ICG), the PRA's statement as to the regulatory capital (Pillar 1 and Pillar 2a) it expects the Bank to hold. The Bank has received an updated ICG from the PRA which came into force from 1 November 2016. As at 31 December 2016, the Bank's Pillar 2a requirement was set at 14.49% of RWAs or £967.4m.


Maximum Distributable Amount

The Bank does not currently meet its ICG and Combined Buffer. Under the PRA rulebook, not meeting the Combined Buffer prevents the Bank from paying dividends, making distributions and creating an obligation to pay variable remuneration during the period of non-compliance. To remain competitive and to enable the attraction and retention of employees, the Bank agreed a fixed pay award for the bulk of employees amounting to £3.6m which has been paid in 2016. For more information refer to the Directors' Remuneration Report.

 

Liquidity

 

Overview

The Bank raises the majority of its funding through accepting retail and commercial deposits. The Bank also maintains a range of funding programmes targeting wholesale investors.

 

The focus of the funding and liquidity strategy of the Bank has been to:

 

•  manage retail deposits to match balance sheet assets and reduce the cost of the liability base;

•  ensure the liquid asset buffer predominantly comprises of highly liquid securities, allowing for limited reliance on short dated secured funding sources;

•  maintain the availability of mortgage collateral to support the secondary liquidity position; and

•  repay wholesale funding to manage the balance sheet and the Bank's liquidity position.

 

Credit rating

On 15 February 2017, Moody's announced that it had downgraded the Bank's long term senior unsecured rating to Ca from Caa2 with a developing outlook. On 21 February 2017 Fitch downgraded the Bank's long term Issuer Default Rating (IDR) to B- from B with an evolving outlook. The Bank's current ratings are:

 


Long

Short

term

term

Moody's

Ca

Not prime

Fitch

B-

B

 

The Bank's current credit ratings continue to result in:

 

•  sub-investment grade ratings on the Bank's senior unsecured debt, in turn, leading to a significant reduction in the demand for these types of instrument;

•  a negative impact on the Bank's ability to access short term unsecured wholesale funding; and

•  heightened collateral requirements within some clearing systems.

 

Liquidity portfolio

The Bank's liquidity resources, as at 31 December 2016, were £8.2bn compared to £10.2bn as at 31 December 2015. As at 31 December 2016 the liquid asset ratio was 13.8% (31 December 2015: 15.6%). The Bank continues to hold liquidity in excess of minimum expectations which is in line with the rest of the industry.

 

Primary liquidity has decreased over the period by £0.7bn and secondary liquidity has decreased by £1.3bn. Primary liquidity consists of liquid assets that are eligible under European Banking Authority (EBA) regulations (high quality liquid assets). Secondary liquidity comprises of liquid unencumbered investment securities not included as part of primary liquidity as well as other forms of contingent liquidity sources. In the 2015 Annual Report and Accounts contingent liquidity included all other non-primary liquid assets. The Bank has now narrowed the contingent liquidity definition in the statutory accounts to only include unencumbered assets (excluding liquid investment securities) eligible for central bank facilities and therefore the 2015 comparatives have been restated to align with this change. The reduction in secondary liquidity in 2016 reflects a combination of amortisation of assets, sales and management of secured funding collateral requirements to support the Bank's funding profile, and collateralisation of the Britannia pension scheme.

 


   2016

2015

Change


£m

£m

£m

Operational balances with central banks

2,571.4

  2,329.3

242.1

Gilts

676.2

  1,450.2

(774.0)

Central government and multilateral development bank bonds

568.5

   760.2

(191.7)

Total primary liquidity

3,816.1

4,539.7

(723.6)

Total secondary liquidity

4,424.2

5,707.4

(1,283.2)

Total liquidity

8,240.3

  10,247.1

(2,006.8)

 

Retail and commercial funding

The majority of the Bank's funding comes from Retail and Commercial accounts. As at 31 December 2016, customer deposits were £22.4bn compared to £22.8bn as at 31 December 2015.

 

Customer deposits reduced over the period by £0.4bn, driven mainly by Retail savings segments. The reduction in Retail savings balances reflects the Bank's strategy to manage its deposit base to match asset funding requirements and manage the cost of liabilities. These activities are partly offset by an increase in Retail current accounts. Corporate deposits remained stable in the year.

 


2016

2015

Change


£m

£m

£m

Current accounts




Retail

4,229.2

3,808.3

420.9

Corporate

2,105.1

2,106.6

(1.5)

Total current accounts

6,334.3

5,914.9

419.4

Instant access savings accounts




Retail

6,384.0

6,580.6

(196.6)

Corporate

482.4

486.1

(3.7)

Total instant access saving accounts

6,866.4

7,066.7

(200.3)

Term deposits and bonds




Retail

3,947.7

4,277.3

(329.6)

Corporate

249.2

281.4

(32.2)

Total term deposits and bonds

4,196.9

4,558.7

(361.8)

Individual savings accounts (ISA)




Retail - ISA Fixed

2,491.7

2,355.9

135.8

Retail - ISA Demand

2,351.5

2,622.6

(271.1)

Total ISA accounts

4,843.2

4,978.5

(135.3)

Other deposits

196.1

290.6

(94.5)

Total customer deposits

22,436.9

22,809.4

(372.5)


Wholesale funding

The Bank uses wholesale funding to supplement Retail and Corporate customer deposits by raising debt to diversify funding sources. The Bank has a variety of wholesale funding sources outstanding, including securitisations, covered bonds, unsecured notes, and repurchase agreements.

 

The repayment of the final £150.0m FLS drawing was made in January 2016. Leek 17 and 18, and Silk Road 3 securitisations matured over the course of 2016.

 


2016

2015

Change


£m

£m

£m

Preference shares, PSBs and subordinated debt

456.0

457.0

(1.0)

Secured funding

1,197.6

2,091.0

(893.4)

Repos

990.6

671.3

319.3

Market borrowing

4.1

10.9

(6.8)

MTNs

405.4

404.9

0.5

Total wholesale funding

3,053.7

3,635.1

(581.4)

 

Figures are based on nominal values and accrued interest as at 31 December 2016 and 31 December 2015.

 

The table below analyses contractual maturities (as opposed to internally expected repayment dates), with the exception of Leek 19 notes being disclosed based on its call date:

 


2016

2015

Change


£m

£m

£m

Repayable in less than 1 month

837.4

522.5

314.9

Repayable between 1 and 3 months

-

159.7

(159.7)

Repayable between 3 and 6 months

528.9

352.4

176.5

Repayable between 6 and 9 months

405.4

243.3

162.1

Repayable between 9 and 12 months

67.9

433.0

 (365.1)

Repayable between 1 and 2 years

-

746.9

 (746.9)

Repayable between 2 and 5 years

1,008.1

259.0

749.1

Repayable in more than 5 years

206.0

918.3

 (712.3)

Total external funding

3,053.7

3,635.1

 (581.4)

 

Basis of preparation

 

The figures referenced and presented within the Detailed Financial Review are on a management accounts basis. A reconciliation of these numbers to the statutory accounts is provided in the segmental information in note 3.

Prior period re-presentations


2015

Re-presentations

Re-presented

2015


£m

£m

£m

Retail net interest income

421.7

(20.0)

401.7

Treasury and Other net interest income

(3.0)

20.0

17.0





Direct costs

(180.0)

22.1

(157.9)

Operations and Head office overheads

(311.9)

(22.1)

(334.0)





Strategic project expenditure

(99.7)

8.0

(91.7)

Severance

-

(8.0)

(8.0)

 

There are three re-presentations to certain segmented allocations included within the 2015 Annual Report and Accounts.

1. £20.0m net interest income from Retail to Treasury relating to the liquidity transfer pricing generated from the Bank's free reserves (equity).

2. £22.1m of costs associated with the property and estates functions has been re-presented in Operations and Head Office overheads from Retail direct costs.

3. £8m of costs associated with the costs of implementing the Bank's revised target operating model, reported separately from strategic project expenditure.

 

Core Balance Sheet re-presentations and impact on prior year net interest margin (NIM)

The Bank has re-presented £0.5bn of assets from unallocated to Core Bank at 31 December 2015 which has reduced the 2015 Core Bank NIM to 1.89%.

 


2015

Re-presentations

Re-presented

2015


£m

£m

£m

Core Bank interest income

460.6

-

460.6





Closing 2014 Core Assets

25,476.2

-

25,476.2

Closing 2015 Core Assets

22,819.0

497.2

23,316.2





Core Bank NIM

1.91%

(0.02%)

1.89%

 

2015 Balance Sheet representations

The Bank has re-presented the 2015 balance sheet. This is driven by a reallocation of £0.5bn of previously unallocated assets and £1.0bn of previously unallocated liabilities across the Core and Non-core Business segments.


Total Bank financial performance

 

Bank performance


2016

2015

Change


£m

£m

£m

Net interest income

394.8

471.5

(76.7)

Losses on asset sales

(13.5)

(121.4)

107.9

Non-interest income

66.7

69.9

(3.2)

Operating income

448.0

420.0

28.0

Operating expenditure

(444.8)

(491.9)

47.1

Operational projects

(33.9)

(49.7)

15.8

Impairment (losses)/gains on loans and advances

(2.3)

48.6

(50.9)

Operating result

(33.0)

(73.0)

40.0

Remediation projects

(141.3)

(124.5)

(16.8)

Strategic projects

(134.3)

(91.7)

(42.6)

Severance

(21.5)

(8.0)

(13.5)

Sale of Visa Europe share

58.1

-

58.1

Share of post-tax profits from joint ventures

0.3

0.7

(0.4)

Conduct and legal risk

(24.9)

(193.7)

168.8

Fair value amortisation

(180.5)

(120.4)

(60.1)

Loss before taxation

(477.1)

(610.6)

133.5

Net interest margin

1.39%

1.42%

(0.03%)

Cost:income ratio

103.7%

100.0%

3.7%





The Bank's statutory loss before taxation for 2016 is £477.1m. The figures referenced and presented on these pages are on a management accounts basis. A reconciliation of these numbers to the statutory accounts is provided in the segmental information in note 3.

 

The 2016 financial results reflect the continued progress against the areas of strategic focus for the Bank, the cost of ongoing legacy issues with regards to fair value unwinds, the impact of a smaller asset base and continued competitive pricing on assets.

 

The cost:income ratio has increased in the year by 3.7% from 100.0% to 103.7%. The reductions in operating expenditure and operational project expenditure has been more than offset by the reduction in interest income and net interest margin.

 

Despite a year on year reduction in the Bank's average cost of funding, total net interest income has fallen as a result of a lower asset base following continued Non-core deleverage, increased competition on new business mortgage pricing and the reduction in the Bank of England base rate. Unity Trust Bank is now regarded as an investment rather than fully consolidated, following a 20.0% reduction of the Bank's shareholding in 2015. The result of this has accounted for £8.3m of the reduction in net interest income.

 

Non-interest income has reduced relative to the prior year. Underlying non-interest income has fallen predominantly within the Retail business, driven by a reduction in Link commission fees following the disposal of the majority of the ATM estate which was completed in Q1 2015 and lower overdraft fees following the launch of the new overdraft proposition in April 2015. The full year impact of reductions in merchant interchange fees on credit cards has further reduced non-interest income. These reductions are partially offset by a one-off gain in February 2016 following the sale of part of the Bank's gilt portfolio.

 

Losses on asset sales have reduced to £13.5m, following a year on year reduction in the rate of Non-core deleverage.

 

The Bank has continued to deliver a significant reduction in operating expenditure, down £47.1m on the previous year, reflecting the progress of cost reduction initiatives. Cost reductions are mainly as a result of the continued focus on improving efficiency and simplification of Bank processes and resulting in the reduction in operating staff costs of £30.3m and the full year recurring benefit from initiatives undertaken in 2015 such as the Branch network rationalisation, FTE (full time equivalents) reductions and the cessation of costs associated with Unity Trust Bank, which are no longer consolidated into the Bank's results.

 

The FSCS levy was £15.1m lower year on year as the Bank was not subject to the payment of the capital levy element in 2016 and overall levy interest payment outlook being lower than the previous year. This also includes a £1.0m refund due to over payment in the prior year.

 

Total project expenditure across operational, remediation and strategic projects was £309.5m. Investment activities continue to progress; these include: the transformation of IT resilience, remediation of systems and processes, transforming the Core Bank's operations and strengthening the Core Bank. Furthermore, the Bank has continued to commit investment into digital channels resulting in upgrades to the internet and mobile banking platforms and improved digital product offerings. Total project expenditure includes costs associated with the programme of work to transform the Bank and also a write-off of assets relating to the transformation element of mortgage outsource servicing, which is no longer being progressed.

 

The Bank's financial performance continued to be impacted by legacy items, particularly the fair value unwind related to the merger with Britannia Building Society of £180.5m. Conduct and legal risk charges totalled £24.9m in the year, a decrease of £168.8m compared to 2015, representing the maturity of the redress and remediation programme and further certainty around the redress requirements of a number of open conduct risks.

 

Operating expenditure


2016

2015

Change


£m

£m

£m

Core direct costs

(126.4)

(143.1)

16.7

Non-core direct costs

(9.4)

(14.8)

5.4

Total direct costs

(135.8)

(157.9)

22.1

Operations and Head Office overheads

(309.0)

(334.0)

25.0

Total operating costs

(444.8)

(491.9)

47.1

Of which: staff costs

(187.7)

(218.0)

30.3

 

Total operating expenditure reduced by £47.1m from £491.9m to £444.8m.

 

Direct costs include those relating to the staff and operations of the specific business units, for example the product and marketing teams, and branch staff within the Retail and SME portfolio.

 

Operations and Head Office costs cover those functions that support Bank-wide operations, including HR, Finance, IT and Risk.

 

Core direct costs

The key drivers of the £16.7m reduction are the savings from the 2015 and 2016 branch rationalisation activity and other cost saving initiatives, including a reduction in discretionary marketing spend. This is in line with the Core Bank strategy of a shift to digital for new and existing customers.

 

Unity Trust Bank is now regarded as an investment rather than fully consolidated, following a 20.0% reduction of the Bank's shareholding in 2015, which has contributed a £10.3m of reduction in Core direct costs year on year. The Bank's shareholding is 5.97% as at 31 December 2016.

 

Non-core direct costs

Continued focus on deleveraging of the Non-core portfolio has driven savings of £5.4m with a significant element of this reduction due to lower staff costs.

 

Operations and Head Office overheads

Operational cost savings have been primarily driven by the 2015 initiatives including ATM rationalisation, process improvement and paper correspondence reduction. These activities combined with further efficiency savings and lower processing costs (due to a reduction of 59 in the branch network).

 

The FSCS levy was £15.1m lower year on year as the Bank was not subject to the payment of the capital levy element in 2016 and overall levy interest payment outlook being lower than the previous year. This also includes a £1.0m refund due to over payment in the prior year.

 

Full time equivalent (FTE) headcount

At a total Bank level, operating staff costs have reduced by £30.3m to £187.7m. Year-end permanent staff numbers (full time equivalents) have fallen by 865 to 3,605 with direct pay falling by £18.3m. The number of short to medium term specialist contractors and temporary resource at year end has increased from 234 to 290 to support a temporary increase of activity in contact centres following Digital migration. Contractor costs have fallen by £5.5m to £17.5m.

Please note that these exclude any FTE and associated expenses relating to the Bank's project expenditure.

 

Project expenditure

 

 

 


2016

2015

 Change


 £m

 £m

 £m

Operational projects expenditure

(19.5)

(27.0)

7.5

Operational projects depreciation

(14.4)

(22.7)

8.3

Operational projects

(33.9)

(49.7)

15.8

Remediation projects expenditure

(131.4)

(121.0)

(10.4)

Remediation projects depreciation

(9.9)

(3.5)

(6.4)

Remediation projects

(141.3)

(124.5)

(16.8)

Strategic projects expenditure

(127.3)

(84.2)

(43.1)

Strategic projects depreciation

(7.0)

(7.5)

0.5

Strategic projects

(134.3)

(91.7)

(42.6)

Total project expenditure

(309.5)

(265.9)

(43.6)

Severance

(21.5)

(8.0)

(13.5)

 

All categories include permanent, contract or temporary resource costs working on these projects within the Bank.

 

Operational projects

Operational projects relate to changes in the regulatory environment and smaller business led initiatives, including process improvements.

 

The charge for 2016 was £33.9m (2015: £49.7m) of which £14.4m (2015: £22.7m) relates to depreciation of previous investments. Key current projects include: Cheque Imaging; Customer Complaints Handling & Reporting; EU Payment Account Directive; and other smaller projects, ensuring regulatory and mandatory requirements of the Bank are met. In addition, there has been £3.0m impairment of smaller assets.

 

2016 spend reduced by £7.5m (excluding depreciation) largely due to the Regulatory Reporting Programme having completed in 2015, with the depreciation reduction (£8.3m) being driven by the transfer of shared assets to The Co-operative Group as part of separation.

Remediation projects

Remediation projects relate to IT remediation and resiliency as well as activity associated with Bank separation from The Co-operative Group.

 

The 2016 cost of £141.3m (2015: £124.5m) includes depreciation of £9.9m (2015: £3.5m). Key projects include: Enterprise Services (ES) outsourcing and separation from The Co-operative Group (£89.1m including £41.6m net reduction of provision); Core IT £14.7m and Data and Reporting £10.6m. Other smaller projects total £17.0m for ongoing remediation issues identified.

 

The key driver for the increased costs against 2015 is additional spend on ES driven by provision raised in 2016 for further cost required to achieve separation £18.9m, and impact of delays with the go live of certain remaining elements now being achieved in February 2017.

 

Strategic projects

Strategic projects relate to those projects that are transformational in nature and deliver cost or income benefits to the business. Project costs of £134.3m (2015: £91.7m), including depreciation of £7.0m (2015: £7.5m), reflect continued investment to enhance capability across the organisation. This includes £81.9m associated with the programme of work to transform the mortgage outsource service, which is no longer being progressed. This amount includes: expenses and fee payments associated with cessation of the transformation contract with the outsourced mortgage provider (£11.0m), a write-off of assets no longer expected to be in use (£48.5m), and other programme costs (£22.4m). The asset write-off of £48.5m includes impairment of intangible assets (£32.5m) and prepayments (£16.0m). Other projects included: digital (£19.0m), further branch transformation with closure of an additional 59 branches in 2016 (£10.9m), and the completion of other smaller projects (£15.5m).

 

Severance

The 2016 costs of organisational design changes are £21.5m (2015: £8.0m), reflecting accelerated implementation of the Bank's target operating model.

 

All categories included permanent, contract or temporary resource costs working on these projects within the Bank.

 

Capital expenditure


2016

2015

Change


£m

£m

£m

Operational projects

(2.2)

6.5

(8.7)

Remediation projects

2.8

9.1

(6.3)

Strategic projects

(21.2)

45.5

 (66.7)

Total project capital expenditure

(20.6)

61.1

(81.7)

 

The Bank capitalises some of its expenditure on projects. Impairment of capitalised assets is offset against any capitalised expenditure, and is included within project expenditure.

 

Operational projects' negative capital expenditure relates to intangible asset impairment resulting from a change in the Bank's strategic cheque imaging solution.

 

Remediation capital expenditure in 2016 related to the models programme; 2015 was driven by Enterprise License Agreement (ELA) (£7.8m) as part of Enterprise Service Outsourcing.

 

Strategic capital expenditure in 2016 includes capitalisation of digital programme costs of £11.3m (2015: £20.2m), offset by impairment of mortgage outsourcing assets from prior years which are no longer expected to be brought into use of £33.6m.

 

Impairment (losses)/gains on loans and advances


2016

£m

 2015

£m

Change

£m

Core impairment

(0.1)

(0.3)

0.2

Non-core impairment

(2.2)

48.9

(51.1)

Total impairment (losses)/gains on loans and advances

(2.3)

48.6

(50.9)

 

Total impairment of £2.3m in 2016 compares with gains of £48.6m of total impairment in 2015.

 

Non-core net impairment charge in 2016 of £2.2m is £51.1m higher than last year. 2015 saw significant impairment write backs driven by assets being disposed or revalued above previous book value. Lower levels of deleverage in the period coupled with cases moving into default have significantly reduced these benefits in 2016. Non-core (losses)/gains on asset sales includes a £9.6m impairment release in connection with the restructure of a Legacy Portfolio syndicated loan during the year. This impairment release is included in 'Impairment gains/(losses) on loans and advances' within the Bank's Income Statement as per note 3 of the financial statements.

 

Core net impairment charge of £0.1m is driven mainly by the Retail business segment.

 

A more detailed analysis of impairments is provided in the Risk Management section.

 

Conduct and legal risk charges


2016

2015

Change


£m

£m

£m

CCA

10.0

(98.7)

108.7

PPI

(36.0)

(71.8)

35.8

Packaged Accounts

-

(16.8)

16.8

Mortgages

(10.4)

(0.6)

(9.8)

Other

11.5

(5.8)

17.3

Total

(24.9)

(193.7)

168.8

 

The 2016 charges relating to conduct and legal risk were £24.9m (2015: £193.7m). The reduction year on year was driven by the significant progress made across the redress and remediation programme.

 

Overall complaint redress performance in the year to 31 December 2016 has been slightly better than expected. The £36.0m charge in 2016 has been recognised to reflect the Bank's year end estimates of the impact of both the FCA Consultation Paper CP16/20 and the FCA announcement on 2 March 2017 that the time bar will end on 29 August 2019. 

 

As at the reporting date the Bank had predominantly completed and closed its Consumer Credit Act (CCA) proactive redress programme. The 31 December 2016 CCA provisions includes a £10.0m net release following near-completion of the programme with the remainder of the provision required to continue work to develop a solution to address accounts becoming non-compliant again. This work is expected to be completed in H1 2017.

 

Overall conduct charges relating to Mortgages were £10.4m. A conduct issue relating to legacy system issues was identified in 2016 resulting in the creation of the Mortgage Rectification programme. This predominantly relates to the incorrect customer monthly mortgage payment calculation resulting in the under or overpayment of interest or capital. The scope and initial view of redress requirements were defined and calculated at YE 2016 resulting in an additional £20.1m provision. Across 2016 pre-existing mortgage remediation activities were substantially progressed and resulted in an offsetting £9.7m release.

 

Impact of internal transfer pricing policy on business segment net interest income

Period on period business segment net interest income is affected by the Bank's internal transfer pricing policy.

 

The Bank's internal transfer pricing policy is designed to compensate liability balances for providing the funding used by the Bank to support and/or grow its asset base. Assets are then accordingly charged for using this funding.

 

The Bank calculates rates to charge all of the Bank's assets and compensate all of the Bank's liabilities based on its cost of funding over time. The rate applied to individual asset or liability balances is based on expected duration assumptions for each balance.

 

These charges and compensation amounts are included within each business segment's net interest income.

 

Therefore, the total volume of assets and liabilities within each business segment has a significant impact on the net amount of transfer pricing it is charged or compensated for across the business segments.

 

The Retail and BaCB portfolios have more liabilities than assets, and therefore they generate a net income from internal transfer pricing. The Non-core portfolio is funded by these net liability positions and therefore receives an overall transfer pricing charge.

 

Treasury manages the charging and compensation of transfer pricing across the business segments and, due to the underlying asset and liability duration mismatch, records the net position within its interest income.

 

The Bank's cost of funding is updated annually and results in changes to the rates which Core assets are charged and the rates which Core liabilities are compensated between periods. For Non-core assets and liabilities the rates have remained unchanged period on period.

 

The Bank's cost of funding has reduced between 2015 and 2016, predominantly as a result of the reduction in Retail liability pricing. This means Core assets are charged a lower transfer pricing rate and Core liabilities are compensated with a lower transfer pricing rate.

 

Core

 

Core contribution


2016

Re-presented 2015

Change


£m

£m

£m

Net interest income

412.7

460.6

(47.9)

Gains/(losses) on asset sales

0.5

(0.8)

1.3

Non-interest income

57.2

52.4

4.8

Operating income

470.4

512.2

(41.8)

Direct costs

(126.4)

(143.1)

16.7

Impairment gains/(losses) on loans and advances

(0.1)

(0.3)

0.2

Contribution result

343.9

368.8

(24.9)

Operations and Head Office overheads

(309.0)

(334.0)

25.0

Operational projects

(33.9)

(49.7)

15.8

Operating result

1.0

(14.9)

15.9

Net interest margin1

1.78%

1.89%

(0.11%)

 


2016

Re-presented 2015

Change


£m

£m

£m

Assets

23,171.4

23,316.2

(144.8)

Liabilities

26,116.7

26,581.9

(465.2)

1. Total Core asset and liability net interest income divided by average asset balances for the year.

 

Core Bank operating profit, comprising Retail, BaCB and Treasury and Other, of £1.0m in 2016 include a number of significant one-off items, including a £15.9m gain on sale achieved on AFS gilts held as a hedge for the LME subordinated debt issuance, a one-off £7.3m interest income credit relating to prior year subsidiary accounting adjustments, and £4.6m of interest income of assets transferred to BaCB from Legacy Portfolio for the majority of 2016, which were transferred back to Legacy portfolio in the during Q4.

 

Core Bank contribution, reduced by £24.9m to £343.9m.

 

Retail contribution reduced by £67.1m, due to a reduction in non-interest and interest income. This reduction is partially offset by direct cost savings.

 

BaCB contribution increased by £12.0m, as a result of lower interest expense on deposits following customer repricing in the prior period and an increase of £4.6m relating to the interest income of assets transferred to BaCB from Legacy Portfolio for the majority of 2016, reflecting a strategic decision to manage these assets within the Core Bank. These assets have subsequently been transferred back to Legacy Portfolio, prior to the reporting date, following a further review.

 

Treasury and Other contribution increased by £30.2m partly as a result of a one-off £15.9m gain on sale achieved on AFS gilts held as a hedge for the LME subordinated debt issuance, and a one-off £7.3m interest income credit relating to prior year subsidiary accounting adjustments. This is partially offset by the fall in net transfer pricing revenue generated within Treasury, following changes in the Bank's balance sheet.

 

These are discussed in more detail in the following sections.

 

Core net interest margin (NIM) has reduced relative to the prior period with a NIM of 1.78% (2015: 1.89%). The Core Bank has delivered significantly higher volumes of mortgages in 2016 when compared to 2015, as a result of more competitive pricing. This results in an overall reduction in the Bank's asset margin which has been partially offset by improvements in underlying liability margins.

 

Core assets have reduced marginally to £23.2bn, down £0.1bn. There have been movements in the year relating to a fall in Treasury and Other assets of £0.7bn and £0.1bn in BaCB which have offset by a £0.7bn increase seen in the Retail asset book.

 

Core liabilities have decreased from £26.6bn at 31 December 2015 to £26.1bn at 31 December 2016.

 

Retail contribution


2016

Re-presented 2015

Change


£m

£m

£m

Net interest income

344.8

401.7

(56.9)

Non-interest income

28.0

43.2

(15.2)

Operating income

372.8

444.9

(72.1)

Direct costs

(114.1)

(116.0)

1.9

Impairment gains/(losses) on loans and advances

(0.6)

(3.7)

3.1

Contribution result

258.1

325.2

(67.1)

 


2016

Re-presented 2015

Change


£m

£m

£m

Customer assets

14,844.6

14,123.2

721.4

Customer liabilities

19,405.1

19,754.8

(349.7)

 

Retail customer assets have seen a positive year in mortgage originations and overall mortgage balance growth of £0.7bn (2015 was a net reduction of £0.2bn). This was driven by originations of £3.1bn (up from £2.8bn in 2015), which continues to be mainly through the Platform Broker channel for which the Bank has won the 'Intermediary Lender of the Year' award. Buy-to-let (BTL) originations have fallen slightly year on year driven by the changes announced in the 2016 Budget and regulatory changes in the BTL affordability calculations required to be implemented by the end of 2016. Redemptions have also been lower this year at £1.7bn (2015: £2.3bn) which is partially due to a slower reduction in mortgage market rates across 2016, making it less attractive for customers to break their present deals than in 2015.

 

Retail customer liabilities have seen a slight, managed decline in the year. Current account balances have seen a continued increase during 2016 of £0.4bn (2015: £0.3bn). This is driven by stock increase after the launch of the Everyday Rewards current account in January and successful incentive led switching campaigns at key points during 2016. Retail savings has seen a managed reduction in balances of £0.8bn, down significantly from the £6.0bn reduction in 2015. This year's reduction sees greater stabilisation in the portfolio after maturity of a large volume of legacy high rate term deposits in line with the Bank's liquidity risk appetite.

 

Retail contribution has reduced by £67.1m to £258.1m (2015: £325.2m). Direct costs have improved marginally by £1.9m which is offset by £56.9m and £15.2m reductions in net interest income and non-interest income respectively.

 

The overall Retail asset margin has narrowed, driven by the competition and the downward trend on mortgage rates seen in the UK mortgage market over the last two years; this is having a more profound effect now that the portfolio is growing.

 

Interest expense on Retail savings has fallen substantially year on year as a result of pricing changes made across 2015 and 2016, this has however been partially offset by significant reduction in the year on year average liability balance along with lower rates received on liabilities, as a result of the Bank's internal transfer pricing policy. The 2016 result has also to a lesser extent been impacted by The Bank of England base rate reduction which has narrowed the margins on variable savings.

 

Lower interest rate expectations versus those anticipated in 2015 have resulted in a lower effective interest rate credit in 2016 of £5.0m (2015: £8.8m).

 

Retail non-interest income reduced to £28.0m (2015: £43.2m), primarily due to a full year's impact of the reduction in size of the Bank's ATM estate which took place across the first quarter of 2015. Additionally the implementation of the revised policy on overdraft fees, which is aligned to the Bank's ethical stance, lower credit card Merchant Interchange Fees and the launch of the Everyday Rewards current account with the associated reward payment costs has accounted for the further reduction.

 

The overall impairment charge for Retail was £0.6m, representing a £3.1m benefit on 2015 primarily within the unsecured loan portfolio driven by the ramp up of collections activity as loans were released from the Consumer Credit Act (CCA) remediation project.

 

Business and Commercial Banking contribution (BaCB)


2016

Re-presented 2015

Change


£m

£m

£m

Net interest income

50.6

41.9

8.7

Non-interest income

12.7

11.6

1.1

Operating income

63.3

53.5

9.8

Direct costs

(6.1)

(9.3)

3.2

Impairment gains/(losses) on loans and advances

0.3

1.3

(1.0)

Contribution result

57.5

45.5

12.0

 


2016

Re-presented 2015

Change


£m

£m

£m

Customer assets

434.9

564.2

(129.3)

Customer liabilities

2,719.3

2,689.2

30.1

 

The BaCB portfolio contributed £57.5m in 2016, a £12.0m increase on prior year.

 

Customer liabilities have remained constant at £2.7bn, with low levels of current account organic growth offsetting outflows of fixed rate deposits.

 

Customer assets have decreased from £0.6bn to £0.4bn as customer repayments have been greater than new business inflows. Net interest income increased to £50.6m in 2016 from £41.9m. The increase is primarily driven by revised hedging policies for non-interest bearing current accounts and a full year's benefit of liability pricing changes implemented in late 2015. This has been slightly offset due to margin compression on liabilities following the Bank of England base rate reduction to 0.25%.

 

As disclosed in the 2016 Interim Financial Report, £0.4bn of Private Finance Initiative (PFI) and Renewable Energy and Asset Finance (REAF) assets were transferred from Legacy Portfolio into BaCB as a result of a re-assessment of the credit quality of the loans, the blended return on capital of the portfolios and the alignment to the Bank's Ethical Policy.

 

Following further management review of the go forward SME Banking strategy in H2 2016, BaCB will focus on developing a business banking proposition for small businesses, delivering simple solutions for the needs of small business customers mainly focused around savings and current accounts. As a result of this review the PFI and REAF assets transferred back to the Legacy portfolio in H2 2016 and are included within the Legacy Portfolio at the reporting date.

 

These assets contributed £4.6m of BaCB net interest income in 2016.

 

Treasury and Other business contribution


2016

Re-presented 2015

Change


£m

£m

£m

Net interest income

17.3

17.0

0.3

Gains/(losses) on asset sales

0.5

(0.8)

1.3

Non-interest income

16.5

(2.4)

18.9

Operating Income

34.3

13.8

20.5

Direct costs

(6.2)

(17.8)

11.6

Impairment gains/(losses) on loans and advances

0.2

2.1

(1.9)

Contribution result

28.3

(1.9)

30.2

 


2016

Re-presented 2015

Change


£m

£m

£m

Assets

7,891.9

8,628.8

(736.9)

Liabilities

3,992.3

4,137.9

(145.6)

 

Treasury and Other contributed £28.3m in 2016 compared to a contribution of (£1.9m) in 2015.

 

Net interest income remained broadly flat rising from £17.0m in 2015 to £17.3m in 2016.

 

The Bank sold £100.0m of the retained Warwick RMBS holdings in May 2016, which contributed a £0.5m gain on asset sale.

 

Non-interest income was £16.5m in 2016 compared to a net expense of £2.4m in 2015. The increase in non-interest income was mainly due to a gain of £15.9m on the sale of AFS gilts held as a hedge for the LME subordinated debt issuance. The LME subordinated debt is now hedged with derivatives. The Bank also ended its participation in the Funding for Lending scheme (final repayment was made in January 2016) and therefore did not incur the same fees as in 2015. In addition, there was a negative variance due to ineffectiveness in hedge accounting.

 

Non-core

 

Non-core balance sheet


2016

Re-presented 2015

Change


£m

£m

£m

Legacy Portfolio

1,471.4

2,034.3

(562.9)

Optimum

2,838.4

3,109.8

(271.4)

Assets

4,309.8

5,144.1

(834.3)

Legacy Portfolio

61.3

282.7

(221.4)

Liabilities

61.3

282.7

(221.4)

 


2016

Re-presented 2015

Change


£m

£m

£m

Customer assets

4,075.4

4,898.9

(823.5)

Customer liabilities

61.3

282.7

(221.4)

 

Non-core total assets decreased from £5.1bn in 2015 to £4.3bn in 2016. The level of deleverage of Non-core assets year on year has reduced significantly as the Bank did not undertake any further securitisation of the Optimum portfolio in 2016. The Bank has however continued to dispose of Legacy Portfolio assets in 2016.

 

In February 2016, £0.4bn of Private Finance Initiative and Renewable Energy and Asset Finance assets were transferred from the Legacy Portfolio into BaCB. Following further management review of the go forward SME Banking strategy in H2, these assets have transferred back and are once again included in the Legacy Portfolio at the reporting date. These assets contributed £4.6m of net interest income in 2016 to BaCB.

 

Optimum, the Bank's Non-core residential mortgage portfolio, reduced from £3.1bn to £2.8bn in 2016, driven by customer capital repayments.

 

Non-core customer liabilities have reduced from £282.7m in 2015 to £61.3m in 2016. As the Bank continues its Legacy Portfolio deleveraging strategy, customers have continued to migrate to other financial institutions.

 

Non-core contribution


2016

2015

Change


£m

£m

£m

Net interest income

(17.9)

10.9

(28.8)

Losses on asset sales

(14.0)

(120.6)

106.6

Non-interest income

9.5

17.5

(8.0)

Operating loss

(22.4)

(92.2)

69.8

Direct costs

(9.4)

(14.8)

5.4

Impairment (losses)/gains on loans and advances

(2.2)

48.9

(51.1)

Contribution loss

(34.0)

(58.1)

24.1

 

Non-core contributed a loss of £34.0m in 2016, compared to a loss of £58.1m in 2015.

 

Non-core net interest income has decreased by £28.8m, following a continued reduction in interest generating assets reflecting the significant deleverage delivered from the start of 2015.

 

The 2016 Non-core loss on sale of £14.0m is £106.6m lower than 2015 due to lower volumes of Legacy Portfolio deleverage and cessation of Optimum sales.

 

The reduction in Non-core contribution is further impacted by a £2.2m net impairment charge on loans and advances in 2016, down from a net write-back of £48.9m in 2015. The significant net write-back in 2015 was driven by assets being disposed or revalued at favourable prices to their net book value resulting in the write-back of previously recognised impairment provisions.

 

Non-core non-interest income is down on 2015 as a result of lower asset balances across the business and will continue to fall as the Bank continues to deleverage its asset base.

 

Direct costs reduced by £5.4m to £9.4m in 2016, primarily as a result of a reduction in staff costs, with significantly fewer staff being required as the book is deleveraged.

 

Outlook

This outlook should be read in conjunction with the Principal Risk and Uncertainties section, the Going Concern disclosures in note 1 of the financial statements and the forward looking statements section on pages 254 to 255.

 

The Bank's announcement on 26 January 2017 noted that the Bank expected its CET1 ratio (in the absence of any management actions) to fall and remain below 10% over the medium term and that it was unlikely to meet its Individual Capital Guidance (ICG) over the planning period to 2020. In addition, the Bank reported that it continued to expect to meet its Pillar 1 capital requirements and to maintain sufficient liquidity to meet its obligations.

 

The Bank's announcement on 13 February 2017 noted that the Bank has always been clear that, although it met Pillar 1 regulatory capital requirements and expected to continue to do so, it needed to build its capital and meet longer term UK bank regulatory capital requirements. This announcement continued by noting that its capacity to do so organically had been constrained by (i) the impact of interest rates that are lower than previously forecast, reducing the Bank's ability to generate income, and (ii) higher than anticipated transformation and conduct remediation costs. The announcement also noted that the Bank has also needed to consider enhanced regulatory capital and MREL6 requirements expected of all UK banks.

 

As a result, and having concluded its annual planning review, the Bank announced the commencement of a sale process, inviting offers for all of its issued ordinary share capital, and that it was considering ways of raising equity capital from existing and new capital providers and a potential liability management exercise of its outstanding public debt.

 

As an alternative to a sale, the Bank's Plan seeks to raise an additional £700m to £750m of CET1 resources. Whilst the structure, terms and timing are to be finalised, this may be achieved via a liability management exercise involving the potential exchange of the Bank's debt securities to equity (taking into account the Bank's creditor hierarchy) alongside an additional primary equity capital raise of approximately £300m to enable the Bank to achieve CET1 ICG4 compliance from 2017 onwards. Furthermore, assuming the successful completion of such capital raise, the Bank is anticipating circa £250m Tier 2 issuance during 2018 and further MREL qualifying debt issuances in 2020/21. If all of these measures are implemented as planned, the Bank expects to be fully ICG5 compliant from 2018 and meet all capital and interim MREL requirements in 2019.

 

2017 Outlook and Longer Term Targets

On the basis that the above Capital Raising7 activity by the Bank is implemented as planned, and that the Bank is also otherwise able to implement the Plan as expected, the Bank is targeting the following:







2016 Reported

2017 Outlook


Longer Term Targets

Balance Sheet





Retail and Business Banking Customer Assets

£15.3bn

Broadly flat


c. £1bn net growth per annum

Other Assets

£12.3bn

c. £10bn


Reduce with Legacy Portfolio run-off






Income Statement





NIM1

1.39%

-


Increasing from 2018, with increasing base rates, up to 10bps per annum

Non-interest income

£67m

-


c. £40m per annum

Operating costs

£445m

c. £410m


c. £350m per annum targeted from 2018

Project costs

£310m

c. £160m


Run rate of c. £50m per annum over the medium term

FV Unwind

£181m

£60m final unwind


-

RoE2

n.m.

n.m.


Strong single digit in 20213 with material progress by 2019






Capital





RWAs

£6.7bn

c. £6.0bn


Broadly stable

CET1 ratio

11.0%

-


22-23% to comply with all regulatory requirements

Pillar 2a and ICG

14.5% of RWAs

CET1 ICG4 compliance


Full ICG5 compliance with c.£250m Tier 2 issuance8 in 2018

Excess Capital

n.m.

n.m.


PRA Buffer5 compliance in 2019 with potential for 2020 dividend9

MREL

n.m.

n.m.


MREL6 issuance8 in 2020/21

1. Calculated based on average total assets

2. Profit after tax over average total equity

3. Based on a capital stack that meets all capital requirements

4. Equivalent to 75% of Pillar 1 and Pillar 2a as 19% of AT1 requirement to be met with CET1

5. Based on the Bank's internal assessment of future Pillar 2a and 2b requirements. Subject to future SREPs

6. Per statement of policy on the Bank of England's approach setting MREL (November 2016) (http://www.bankofengland.co.uk/financialstability/Documents/resolution/mrelpolicy2016.pdf).

7. For significant execution risks and material uncertainties regarding successful completion of the Capital Raising, which may not be completed on acceptable terms, or at all, see 'Principal Risks and Uncertainties' section.

8. Tier 2 and MREL issuance depends on Capital Raising, Bank credit rating improvement and conducive prevailing capital markets. Issuance may not be completed on acceptable terms, when needed or at all.

9. Subject to regulatory capital requirements, including CRR Maximum Distributable Amount restrictions on dividends and distributions, PRA approval and the availability of distributable reserves. The availability of distributable reserves is expected to require a shareholder and court approved reduction of share capital.

10. Subject to shareholder, bondholder and other approvals, For significant execution risks and material uncertainties regarding successful completion of the Capital Raising, which may not be completed on acceptable terms, or at all, see 'Principal Risks and Uncertainties' section.

n.m. refers to not meaningful

 

As at 31 December 2016 the Bank's ICG Pillar 2a requirement was 14.49% of RWAs, which equated to a capital requirement of £967.4m. The Bank believes its Pillar 2a requirement should reduce materially over time and has a target end state of c. 9.5% of RWAs5. The targeted reductions are expected to be driven by:

 

•  operational risk requirements decreasing, as conduct issues are remediated and the risk of business disruption from operational events, including system failures, is reduced;

•  execution risk decreasing as the Bank completes its transformation programme;

•  Interest Rate Risk on the Banking Book (IRRBB) decreasing as retained Warwick notes expected to mature in June 2020;

•  reduced model risk requirements as the Bank's IRB remediation programme concludes, supporting add-on removal; and

•  the outcome with regards to the Pace separation negotiations.

 

There are significant execution risks and material uncertainties regarding successful completion of the Capital Raising, which may not be completed on acceptable terms, or at all. See Principal Risks and Uncertainties section on pages 35-48.

 

Detailed Key Performance Indicators

The key performance indicators presented below1 reflect the way in which the performance of the Bank has been measured during 2016. Management continues to review these measures on an ongoing basis.

Capital KPIs

 

Definition

Why it is important for the business and management


CET1 Ratio

Capital requirements are part of the regulatory framework governing how banks and depository institutions are measured. Capital ratios express the Bank's capital as a percentage of its RWAs as defined by the Regulatory authorities. CET1 is broadly equivalent to tangible shareholders' funds less certain capital deductions.

The Bank is required to maintain minimum regulatory capital and capital ratios at all times. The Bank must have a CET1 ratio of at least 6% in order to meet Pillar 1 capital requirement.

 

2016: 11.0%

2015: 15.5%

Total Capital Ratio

The ratio of total capital resources to the Bank's total RWAs.

The Bank is required to maintain minimum regulatory capital and capital ratios at all times.

The total capital ratio is important for the

Bank's ability to withstand any future market wide or individual stresses.

2016: 17.7%

2015: 21.6%

 

Leverage Ratio

A ratio calculated by reference to CRD IV Tier 1 capital (after deductions) divided by adjusted balance sheet exposure.

Under UK leverage ratio framework, a 3% minimum leverage ratio requirement applies to firms with retail deposits greater than or equal to £50bn from 1 January 2016 onwards. While the Bank does not currently have a minimum leverage ratio requirement, it continues to assess its leverage ratio against broader UK requirement.

2016: 2.6%

2015: 3.8%

Total RWAs

RWAs are required to be calculated for the Bank to provide for three types of risk:

i Credit risk.

ii Market risk.

iii Operational risk.

The Bank considers market risk within credit risk.

The Bank's capital ratios are calculated from the sum of the three RWA categories.

The Bank is required to maintain minimum regulatory capital and capital ratios at all times.

Calculation of total RWAs is part of the calculation of these ratios.

 

 

 

 

 

2016: £6.7bn

2015: £7.4bn

Returns KPIs

 

Definition

Why it is important to the business and management

 

Statutory

profit/(loss)

before tax

This represents operating profit/(loss) less intangible asset impairment, the cost of customer redress, levies, taxes and various non-recurring items.

This is a primary profitability measure used by management to assess performance.

2016: (£477.1m)

2015: (£610.6m)

Net interest

margin2

Net interest income (the difference between interest received from loans/other assets and interest paid out on deposits/other liabilities) divided by average total assets.

The net interest margin is the key measure of the Bank's ability to generate revenue.

 

2016: 1.39%

2015: 1.42%

 

Cost:income

ratio

The proportion of the Bank's revenue which is used to fund its operating costs calculated by dividing operating costs plus operational projects (including the associated depreciation) by operating income excluding losses on asset sales.

A principal measure of the efficiency of the Bank's overall operations.

 

 

 

2016: 103.7%

2015: 100.0%

 

1.  KPIs are calculated on a management accounts basis as this is how we manage our business.

2.  Net interest margin is calculated as net interest income divided by the average of the opening and closing asset balances for the period.


HR Key performance indicators


Definition

Why it is important to the business and management


Colleague engagement

The Bank measures the engagement level of its employees based on responses to questions covering five areas. This is a measure of colleague sentiment towards the Bank based on their advocacy, confidence, commitment, pride and their willingness to give discretionary effort that supports productivity and performance.

Our people are vital to our success. Given the challenges the Bank has faced, it is essential that colleagues continue to feel engaged and committed to delivering the 2017-2021 Strategic Plan.

 

 

 

 

2016: 64%

2015: 66%

 

 

 

 

 

Gender diversity

YE 2016

Female No.

Female %

Male No.

Male %

Board1

2

17%

10

83%

Executive Management Team2

3

33%

6

67%

Other employees

2,517

59%

1,728

41%

Grand total

2,522

59%

1,744

41%

 

YE 2015

Female No.

Female %

Male No.

Male %

Board1

2

18%

9

82%

Executive Management Team2

2

22%

7

78%

Other employees

3,078

61%

1,988

39%

Grand total

3,082

61%

2,004

39%

1. Board: Includes Executive and Non-Executive Directors.

2. Executive Management Team: Includes senior managers who have responsibility for planning, directing or controlling the activities of the Company.

 

The definitions used for reporting in this section have been updated to ensure consistency of approach across Bank reporting. The 2015 categories are in line with ICSA: The Governance Institute guidance for the content of an annual report for UK companies.

 

Core Bank KPIs

The Core business represents lines of activity that are consistent with the Bank's strategy and risk appetite and includes Retail, BaCB and Treasury and Other.

 


Definition

Why it is important to the business and management


Net interest margin

Net interest income (the difference between interest received from loans and other assets and interest paid out on deposits and other liabilities) divided by average total assets.

The net interest margin is the key measure of the Core Bank's ability to generate revenue.

2016: 1.78%

2015: 1.89%

 

Customer deposits

The amount of money customers hold in their accounts with the Bank, also known as customer liabilities.

The Core Bank needs customers to deposit money with the Bank so that it is able to fund loans to other customers.

2016: £22.1bn

2015: £22.4bn

Customer assets

The amount of money the Bank has lent to customers as loans.

The interest received on loans is the Core Bank's primary source of revenue.

2016: £15.3bn

2015: £14.7bn

Primary current account holders

Customers holding an account with the Bank who on average pay in £800 or more per month.

A measure of the size of the Core Bank's active customer base.

2016: 664,268

2015: 655,965

Credit RWAs

Total assets adjusted by different risk weightings for different types of assets (to reflect their inherent potential for default) with the aim of more accurately reflecting the Bank's exposure to potential losses.

Asset types which attract high risk weightings require the Core Bank to hold more equity capital to absorb potential losses.

 

 

2016: £3.9bn

2015: £3.7bn

 

 

Total current account holders

The total number of open current accounts the Bank has.

Current accounts are the cornerstone of the Bank's relationship strategy.

2016: 1,435,470

2015: 1,431,323


Non-core Bank KPIs

The Non-core business consists of those asset classes which are not consistent with the Bank's Core strategy and are managed to achieve the most appropriate asset value on an individual portfolio basis or are targeted for run down or exit.

 


Definition

Why it is important to the business and management


Customer assets

The amount of money the Bank has lent to customers as loans.

The interest received on loans is the Bank's primary source of revenue; conversely, impairments on those loans create losses which reduce capital.

2016: £4.1bn

2015: £4.9bn

 

Credit RWAs

Total assets adjusted by different risk weightings for different types of assets (to reflect their inherent potential for default) with the aim of more accurately reflecting the Bank's exposure to potential losses.

Asset types which attract high risk weightings require the Bank to hold more equity capital to absorb potential losses. Reducing RWAs in

Non-core will, all other things being equal, increase the Bank's CET1 ratio.

2016: £2.0bn

2015: £2.8bn

 

 

 

Principal risks and uncertainties

This section summarises the principal risks and uncertainties facing the Bank and how they are being managed or mitigated. This is not a comprehensive description of all the risks and uncertainties facing the Bank. It is comprised of three sections:

 

•  'Background and the Bank's 2017-2021 Strategic Plan' (the Plan) provides the context in which the Bank's principal risks and uncertainties should be understood and includes an overview of the principal risks and uncertainties relating to important management actions which form part of the Plan and upon which success of the Plan depends;

 

•  'Regulatory Deficiencies' summarises the Bank's deficiencies against regulatory requirements and expectations which constitute principal risks and uncertainties; and

 

•  'Other Key Risks' outlines other key financial and non-financial risks and uncertainties as identified by the Bank's Risk Management Framework (RMF) and how they are being managed or mitigated. These are linked to the Bank's RMF risk taxonomy: see further 'Risk Management - section 1.4 Principal Risk Categories'.

 

1. Background and the Bank's Plan

The Bank required a £1.5 billion recapitalisation in December 2013 enabling a turnaround plan to be started. Although the Bank has since made considerable progress in implementing its turnaround plan, the Bank's capacity to build its capital to meet current and future UK bank regulatory capital and loss absorbing requirements has been constrained principally by the impact of lower interest rates that are forecast to remain lower for longer than previously forecast and by higher than expected transformation and conduct remediation costs. To address these issues, as part of its annual review process relating to the 2016 financial year and concluding its annual planning process, the Bank recently finalised its Plan for 2017-2021, which we refer to as the Plan.

 

The Board has announced a proposed sale of the Bank, which may or may not result in a committed offer to acquire the Bank. The Plan approved by the Board and accepted by the PRA anticipates various important management actions, including, as an alternative to a sale of the Bank, successfully raising between £700m and £750m of additional CET1 resources from existing and new capital providers to raise sufficient CET1 to meet the CET1 component of the Bank's future ICG regulatory capital requirements. The structure, terms and timing of this CET1 capital raising are being finalised though it may include a liability management exercise or other restructuring (LME), involving exchanging certain classes of the Bank's bonds into equity (taking into account the relative ranking of these bonds in the Bank's creditor hierarchy) alongside a potential primary equity capital raising. We refer to these CET1 capital raising actions as the Capital Raising. The PRA has accepted the Bank's Plan and the PRA intends to closely monitor the Bank's performance against it. There is a risk that the Bank does not successfully deliver all or part of the Plan when planned or targeted. Failure to successfully implement, or a delay in implementing, the Plan and completing the Bank's turnaround transformation plan may adversely affect the Bank's business, operating results, financial condition, prospects, regulatory capital position and its ability to comply with its regulatory capital requirements.

 

Going Concern Uncertainty

As the Bank has disclosed in its financial statements for the past 3 years, its financial statements (see Note 1.2 to the Bank financial statements) indicate, and the audit report on those financial statements contain an 'emphasis of matter' statement, indicating that there are material uncertainties which may cast significant doubt on the Bank's ability to continue as a going concern.

 

Risks relating to the sale of the Bank and Capital Raising

In the near term, these material uncertainties are principally the significant execution risks and material uncertainties regarding a successful completion of a sale of the Bank or a Capital Raising. The structure, terms and timing of a sale or Capital Raising is being finalised, though the Bank has engaged financial and other advisers to assist and advise on these matters. Successful completion of a sale or Capital Raising may depend on greater certainty on the scale of future pension obligations, which may be difficult to resolve in the short term and the PRA expects the Bank to seek to advance negotiations with The Co-operative Group and the Pace trustee. Completion of a sale or Capital Raising are each subject to a number of uncertainties beyond the control of the Bank including obtaining requisite regulatory, shareholder and bondholder approvals, the agreement and signing of definitive documents on acceptable terms and conducive market conditions.

 

Any sale of the Bank is subject to risks and uncertainties. These include, for example:

•  whether there are any willing purchaser(s) that are acceptable to our shareholders and other stakeholders that can and will buy the Bank when needed, on terms acceptable to our shareholders and other stakeholders, or at all;

 

•  whether any purchaser (or group of purchasers) will be able to raise or restructure any financing that is necessary to complete the purchase of the Bank, when needed on acceptable terms, or at all;

 

•  whether any purchaser will obtain any necessary regulatory or other approvals to complete the purchase of the Bank on acceptable terms to the purchaser, or at all; or

 

•  whether a purchaser (or group of purchasers) that acquires the Bank is able to successfully integrate the Bank into its operations and do so in a manner consistent with the values and ethics of the Bank. Failure to do this could negatively impact the Bank's brand and business.

 

In addition to announcing that it was starting a sale process, the Bank also announced that it is also considering the Capital Raising to mitigate against the risk and uncertainties that the Bank may not be sold, or that any sale may be delayed. The principal risks and uncertainties relating to the Capital Raising include: whether the Capital Raising will raise sufficient CET1 capital, on acceptable terms, when needed, or at all; the Bank's ability to complete any primary equity raising component of the Capital Raising following a failure, or perceived failure, to sell the Bank; which classes of the Bank's bondholders (having regard to the creditor hierarchy) will be included in the LME; the failure of the requisite majorities of shareholders, bondholders or creditors to approve and/or participate in the LME and/or equity raising components of the Capital Raising or the failure to obtain any other regulatory, court or other approvals necessary to complete the Capital Raising, when required, or at all; regulators concluding that the amount of CET1 capital actually raised in the Capital Raising is insufficient to meet the Bank's regulatory capital requirements; the Bank becoming involved in disputes and legal proceedings that prevent or delay successful implementation of the LME or primary equity raising, or disputes that render it unlawful and invalid, or are very costly, resulting in a requirement for the Bank to raise further CET1 capital.

 

There are significant execution risks that the Bank may not complete a sale of the Bank or a Capital Raising on acceptable terms, when needed, or at all. There is a risk that, if both the sale of the Bank and Capital Raising fail, the Bank will be unable to achieve the management actions and targets in the Plan, including the '2017 Outlook' targets and 'Longer Term Targets' outlined in 'Detailed Financial Review: Outlook', unable to become ICG compliant as expected in the Plan and, therefore, fail to deliver its Plan successfully. If the Bank is unable to successfully deliver its Plan (or its delivery is delayed in whole or in part); then the Bank's regulators have the discretion to exercise one or more of various powers over the Bank. They can agree a revised plan, require some other actions to be taken on the part of the Bank or, in the absence of any of these, the FCA and/or PRA may vary or restrict the Bank's permissions or business, and the Bank of England may impose particular directions or a special resolution procedure on the Bank under the Banking Act 2009 1. A special resolution procedure is likely to have a significant adverse effect on some or all of the Bank's existing and future shareholders, bondholders (whether or not those bondholders are included in any LME), customers and colleagues.

 

If the sale of the Bank does not proceed but a Capital Raising is successful, it is still anticipated that the Bank would need to undertake further capital market issuances, including approximately £250m of Tier 2 capital and further MREL debt issuances, over the life of the Plan. There is a risk that the Bank may be unable to complete these issuances in the amounts or when planned or required by the Bank's regulators, on acceptable commercial terms, or at all.

 

Risks of Sale/Capital Raising uncertainties on the Bank's reputation and business

In the meantime, the uncertainties surrounding whether or not the Bank will be sold and, if sold, to whom and related press speculation about the Bank's future (and the success or failure of the sale or Capital Raising), may damage the Bank's brand and reputation. Such reputational damage may negatively impact our ability to attract and retain Retail deposits, customers, colleagues and suppliers, and, therefore, may have an adverse effect on customer and investor confidence, the Bank's business, operating results, financial condition, its prospects and the Bank's ability to successfully deliver the Plan. The Bank's strategy is based in part on the Bank's reputation as being fairer, more responsible and trusted than its competitors. This reputation may be undermined by any change in ownership of the Bank resulting from any sale or the Capital Raising.

 

Risks relating to the other key assumptions in the Plan

In addition to the risks and uncertainties regarding a sale of the Bank or Capital Raising, there is a risk that the Bank may fail to successfully deliver other management actions and parts of its Plan, when planned or targeted. The key assumptions underlying the Plan include:

 

Net interest margin

The Plan targets steady increases in the Bank's net interest margin, in line with forecasted interest rate increases assumed to begin in 2018, of up to 10bps per annum. These targets are most susceptible to interest rate changes and competitive pressures. Lower for longer interest rates will restrict the Bank's ability to increase net interest margin and, consequently, restrict organic capital generation and profitability, as well as improvement in cost:income ratios. The Plan also assumes our market share in new business mortgage assets is preserved, allowing the Bank to significantly increase prime residential mortgage asset volumes in Retail and Platform over the life of the Plan, and that unsecured loan and credit card balances decrease from 2017. The personal financial services industry is mature, so growth often requires taking market share from competitors. The Bank faces risk of losing market share to other banks, building societies and insurance company competitors, which may impact the Bank's plans to increase Bank profitability based on preserving its market share of new mortgage origination and other products over the life of the Plan. There is a risk that base rates may not increase as soon or as much as forecast, that competitive pressures reduce the Bank's market share or do not enable margins to increase as planned or that regulatory pressures constrain the anticipated growth in volumes. The Plan assumes asset pricing increases across the market generally as a result of the lower for longer interest rate environment, generating fewer available options for retail banks to deliver improved net interest margin. If, and to the extent that, these increases are not forthcoming as assumed in the Plan, then the Bank's actual net interest margin trajectory could be significantly lower than targeted.

 

Increasing mortgage sales

The Plan targets growing the Bank's net core customer assets by approximately £1 billion in each year of the Plan, primarily driven by the Bank's Platform brand. There is a risk that the growth of these assets is significantly less than planned, that new mortgage origination may be significantly less than expected due to any number of internal or external factors, e.g. a possible contraction of the UK mortgage market, or that mortgage origination may be disrupted if the Bank's mortgage process outsourcer is unable or unwilling to perform its services and/or that the pressure to achieve the targeted increases may create new conduct, legal and regulatory risks. There is also a risk that the Bank may be unable to maintain access at an appropriate cost to liquidity and funding to fund the requisite level of asset origination targeted in the Plan, including a risk that the Bank may be unable to gain access to current or future central bank funding facilities and initiatives.

 

Reduced losses on asset sales

The Plan assumes reduced losses on the sales and deleverage of the Bank's Legacy Portfolio business in 2017 and no further material losses on other assets sales. There is a risk that any remaining asset sales may not be completed on acceptable terms, or at all, or may result in greater unprovided losses than planned (or be delayed).

 

Non-interest income

The Bank's non-interest income has decreased in recent years to £66.7m in 2016, principally as a result of the reduction in the Bank's ATM network and lower rates on merchant interchange. The Plan targets non-interest income remaining broadly stable at approximately £40m per annum for the life of the Plan. Within this it is assumed there is an increase in fees for certain liability products in order to achieve this. Changes in the fees could result in higher than anticipated out flows of customer deposits and the need for the Bank to replace these out flows with more expensive funding sources, further decreasing net interest income more than assumed in the Plan and/or lower than expected overall non-interest income.

 

Transformation Programme Delivery

The Plan assumes the Bank is able to deliver the remaining transformation, remediation and change programmes and the cost reduction initiatives already underway without material deviation from planned timescales and costs. The Plan targets operational, remediation and strategic project expenditures reducing from £310m in 2016 to approximately £160m in 2017 and then targets project costs of approximately £50m per annum over the medium term: significant targeted reductions from the Bank's project costs of recent years. Historically, the Bank has experienced significant cost overruns when implementing complex large-scale change projects, and some projects have not delivered the planned benefits. Any deficiencies in appropriate governance and related programme management processes to assist with the satisfactory delivery of these activities would have an adverse effect on the Bank's operating results and financial condition compared with those targeted in the Plan. There are risks that the Bank may be unable to complete this programme when planned, and that it may cost significantly more than targeted or have a reduced scope for the same targeted costs, or deliver less benefits than planned, thereby impacting associated cost reductions or income generation plans.


Lower cost:income ratio

The Bank's continuing high cost:income ratio, partly as a result of prior issues with the Bank's turnaround plan, inhibits the Bank's profitability and may hinder its ability to raise new capital. The Bank is expected by the PRA to demonstrate that it has the means and ability to deliver in the medium term an acceptable cost:income ratio. The Plan therefore targets operating costs reducing from £445m in 2016 to approximately £410m in 2017, further reducing to a long term target of £350m per annum from 2018. These operating cost reduction targets assume that the Bank successfully effects significant cost reduction initiatives in the near term and that operating expenditure and project costs, including remediation, integration and resiliency projects, are significantly lower during the remaining years of the Plan than in recent years. There is a risk that the Bank may be unable to achieve these intended cost reductions, when planned, or at all. Operating costs may be higher than expected, particularly in the latter half of the Plan. There is a risk that the Bank's cost:income ratio continues to negatively impact its profitability and its capital position.

 

Conduct Provisions and Legal Risks

In the three years ended 31 December 2016, there have been total conduct risk charges of £319m. The Plan assumes no significant new conduct or legal risk provisions during the planning horizon. There is a risk that the Bank becomes exposed to significant new conduct or legal risks, either by the Bank discovering significant new conduct and legal risk issues from the Bank's legacy systems and controls or from regulatory changes imposed on banks generally or on the Bank in particular. Conduct provisions for PPI and other known issues, as well as new conduct and legal risk issues that may emerge during the life of the Plan, and related remediation and project costs, may be much higher than expected over the life of the Plan.

 

Risk Weighted Assets (RWAs)

The Plan targets RWAs falling to approximately £6.0bn by the end of 2017 and then targets RWAs remaining broadly stable over the life of the Plan. RWAs may be significantly greater than targeted due to worsening economic conditions (e.g. higher unemployment and lower property prices could result in higher levels of impairments) and any material increases in RWAs will significantly increase our capital requirements beyond those planned for. The RWA targets assume remediation of the Optimum portfolio temporary adjustment (mentioned below in 'Optimum portfolio Risk Weighted Assets temporary adjustment') and further deleverage of the Legacy Portfolio resulting in the losses assumed in the Plan. If either of those actions is unsuccessful, RWAs could remain higher than those targeted in the Plan, resulting in greater capital requirements than anticipated and lower CET1 ratios than targeted.

 
Other planned capital markets issuances

The Plan targets further capital issuances starting with approximately £250m Tier 2 debt issuance in 2018, and MREL qualifying debt issuances in 2020 and 2021, assuming that, if the sale of the Bank does not proceed, the Capital Raising is successfully completed. There are risks that the Bank will be unable to raise the required capital on acceptable terms, when planned or at all and, that the Bank will be unable to achieve ICG compliance when planned, or at all. See 'Anticipated Regulatory Capital Requirements' below.

 

Continued regulatory support

The Plan assumes that the PRA and other regulators continue to be supportive of the Bank's current inability to meet the regulatory requirements discussed under 'Regulatory Deficiencies' and 'Other Key Risks - Regulatory Risk and Conduct Risk' below. There is a risk that the PRA or other regulators may exercise their discretion to withdraw their support for the Bank at any time.

Pension Funding Requirement

Given the uncertainty that remains around separation of the Bank's liability to the Pace pension scheme, the Bank's Plan makes a non-binding assumption for planning purposes that the Bank continues to provide a £5m per annum contribution to the Pace pension scheme deficit. There is a risk that the Bank may be required to pay significantly more than assumed in the Plan as a result of

 

•  the 'last man standing' clause should one or more participating employers fail;

•  contribution negotiations in the absence of Pace separation (for example, in the context of the 5 April 2016 Pace valuation currently underway); or

•  the outcome of PACE separation negotiations.

 

In addition, the Bank may be required to fund an increased level of deficit in connection within the Britannia pension scheme depending on the outcome of the next triennial valuation. See further section 3.10 'Pension Risk' below.

 

Ability to Pay Dividends

The Bank does not expect to pay dividends in the near future (see 'Directors' Report'). The Bank's ability to pay any dividends at any time in the future is subject to the Bank's compliance with regulatory capital requirements, including CRR Maximum Distributable Amount restrictions on dividends, distributions and variable remuneration, PRA approval and the availability of distributable reserves. In addition, the availability of distributable reserves is expected to require a shareholder and court approved reduction of share capital.

 
Return on Equity (ROE) targets

The targeted ROE relies on the Bank's ability to successfully mitigate the risks outlined above, particularly the Bank's ability to widen net interest margin and develop its interest income and deliver the anticipated cost reduction and resulting cost:income ratio. If any of the risks above do materialise, this may result in lower future returns and a lower than targeted ROE.

 

A failure or delay in implementing these other important parts of the Bank's Plan may adversely affect the Bank's business; operating results, financial position, and prospects; and, its regulatory capital position and ability to comply with its regulatory capital requirements.

 

The Bank's ability to deliver the Plan is heavily influenced by external factors which may mean that the underpinning internal assumptions may be incorrect and negatively impact the Bank's performance. Many of these are similar to those faced by other financial institutions, for example:

 

•  lower interest rates that remain lower for longer than forecast;

•  whether assets in the Bank's Legacy Portfolio can be sold on acceptable terms, or at all;

•  deterioration in general economic conditions, instability of global financial markets including the effect of macro political conditions in Europe (including forthcoming elections in certain EU member states and the unresolved Euro sovereign debt issues);

•  the UK's impending departure from the EU, which may occur as early as April 2019;

•  possible contraction of the UK mortgage market negatively impacting loan book growth;

•  systemic capital markets volatility;

•  UK banks' reaction to the Bank of England stimulus package (base rate, gilt purchases, Term Funding Scheme);

•  higher unemployment and lower property prices increasing impairments;

•  further clarity around future regulatory requirements, including expectations regarding MREL requirements2;

•  the management of credit risk, interest rate risk, currency risk and market risk;

•  risks stemming from regulatory change, increasing regulatory enforcement and an increasingly litigious environment; and,

•  the impact on the Bank's operating results, financial and capital position of the implementation of accounting standards and interpretations, including, with effect from 1 January 2018, IFRS 9 on the Bank's accounting of financial assets and liabilities, impairment of financial assets and hedge accounting.

 

The development and implementation of the Plan, including the '2017 Outlook' targets and 'Longer Term Targets' outlined in 'Detailed Financial Review: Outlook', required difficult, subjective and complex judgements including targeted effects of management actions, assumptions, projections and forecasts of economic conditions and other conditions beyond the control of the Bank. Subjective and complex judgements were also involved in the Plan forecasts and assumptions regarding such key performance indicators as: net interest margin, cost:income ratio, CET1 ratio, leverage ratio and RWAs. If, and to the extent that, these judgements prove to be incorrect there is a risk that the Plan may not sufficiently address the Bank's current difficulties or deliver the expected benefits.

 

2. Regulatory Deficiencies

The following section summarises the principal risks and uncertainties relating to the Bank's position in relation to deficiencies against regulatory requirements and expectations. These deficiencies have existed for some time and will continue for some years to come while the Bank implements its Plan. The successful implementation of the Plan depends upon the ongoing support of its regulators and supervising authorities regarding any continuing and intervening deficiencies to required regulatory standards.

 

2.1 Anticipated Regulatory Capital Requirements

Although the Bank meets and expects to continue to meet its Pillar 1 capital requirements under CRR, the Bank is not currently compliant with its ICG requirement (the mandatory capital requirement issued to the Bank by the PRA covering the Pillar 2a requirements the Bank is required to hold in excess of Pillar 1). The Plan indicates that, absent of management actions, increased operating losses of the Bank over the Plan period result in an increased deficit to the Bank's projected ICG requirements and defer compliance beyond the life of the Plan. In January, the Bank announced that it expects its CET1 ratio, in the absence of management actions, to fall and remain below 10% over the medium term. As a result, while the Bank continues to expect to meet its Pillar 1 requirements, there is a risk that the Bank's projected headroom above the Pillar 1 regulatory minimum would not be sufficient to enable the Bank to issue MREL qualifying debt on acceptable terms in the significant amounts, and when needed, as indicated by the Bank of England in its non-binding indication of future MREL requirement to the Bank. The Bank does not currently have sufficient capital resources to withstand a severe stress scenario under its current in force PRA buffer.

 

To mitigate that risk, the Plan, therefore, contemplates that the Capital Raising would raise a significant amount of additional CET1 capital sufficient to help enable the Bank to increase the CET1 component of its headroom above Pillar 1 requirements. The Bank anticipates that if the Capital Raising is successful and the Bank's credit risk capital modelling deficiencies are successfully remedied (see section 2.2: 'Risks Relating to the Bank's Credit Risk Capital Modelling Requirements' below), the Bank will be able to meet its Pillar 1 and Pillar 2a requirements, thereby targeting returning to ICG compliance on a sustainable basis following a Tier 2 capital issuance in 2018. This projected return to ICG compliance is based on the Bank's internal view of the how its ICG requirements will evolve over time and, thus, there is a risk that the PRA could set an ICG requirement different to that which the Bank has assumed in the Plan.

 

In addition, the Bank's Plan targets MREL qualifying debt issuances in 2020 and 2021 assuming successful completion of the Capital Raising, the Bank becoming ICG compliant as discussed above and improving its profitability as contemplated in the Plan. In the connection with the Bank's former strategic plan that contemplated MREL qualifying debt issuances starting in 2018, the PRA and the Bank of England have indicated their strong preference that the Bank effect an earlier profile of MREL qualifying debt issuance. There is, therefore, a risk that, the Bank may be required to issue MREL qualifying debt earlier than 2020 and 2021 and be unable to do so (whether or not the Bank has successfully completed the Capital Raising and other actions discussed above to return to ICG compliance), in which case the Bank's regulators will be entitled to require the actions or exercise the powers discussed below.

 

Even if the Capital Raising is successful, the Bank's ability to complete the planned Tier 2 capital and MREL qualifying debt issuances may be dependent on an improvement in the Bank's credit rating from its current sub-investment grade credit rating and conducive capital markets prevailing at the time. There is, therefore, a risk that the Bank may be unable to complete these issuances on acceptable terms, in the amounts and when contemplated in the Plan or when required, or at all.

 

Given the risks and uncertainties relating to the Capital Raising mentioned in section 1, there is a risk, especially if the Bank is not sold and is unable to successfully complete the Capital Raising, that the Bank may be unable to raise the additional capital and MREL qualifying debt contemplated in the Plan when planned or required, on acceptable terms, or at all.

 

Whether the Bank is able to meet its ICG during that period will also depend on a number of other factors, within and outside the control of the Bank, including its ability to deliver its Plan, and UK economic and market conditions generally.

 

If the Bank fails to meet its capital, ICG or MREL requirements or its plan to comply with those requirements, the Bank's Regulators can agree to accept the Bank's original plan, a revised plan, use their respective powers to require some other remediating action on the part of the Bank or in the absence of any of these, the Bank of England may exercise its above-mentioned powers under the Banking Act 2009. See further 'Going Concern Uncertainty' in section 1 above.

 

CRR requirements apply to the Bank on both a Consolidated basis and on a Solo entity basis. Solo refers to the legal entity that holds a banking licence i.e. the Co-operative Bank plc, while Consolidated refers to the Bank and all of its subsidiaries. Capital Requirements Regulation (CRR) allows banks to apply for a Solo Consolidation permission to include subsidiaries that meet certain criteria within its Solo position. The Bank has received the Solo Consolidation permission; however, it does not cover all of the Bank's subsidiaries (these are referred to as non-Solo entities). As a result of the Bank's Solo CET1 ratio being lower than the Consolidated position, there is a lower projected headroom above its Solo Pillar 1 regulatory minimum as compared to the Consolidated position. The Bank is currently considering options to repatriate CET1 capital from the non-Solo entities to the Solo entity to reduce the CET1 differential and improve the Bank's projected headroom to Pillar 1 regulatory minimum on a Solo basis. There is a risk that if the Bank is unable to identify appropriate options and obtain the requisite regulatory non-objections to complete the capital repatriation to the Solo entity in the amounts and in the time frame proposed, or in its entirety, the Bank may suffer a material erosion of its capital resources. This may result in a breach by the Bank of its regulatory minimum requirements on a Solo basis and before any breach in the Consolidated position.

 

The Bank's ability to enhance its capital positions to meet regulatory capital and MREL requirements will be kept under close review by the Board, the Bank of England and the PRA, periodically, over the life of the Plan.

 

There is a risk that, whether or not the Bank is able to successfully complete the sale of the Bank or the Capital Raising and raise the Tier 2 capital and MREL qualifying debt it requires when needed, the Bank's regulators may enforce stricter regulatory capital and MREL requirements on the Bank (whether specifically applicable to the Bank or to banks more generally) or may withdraw their support for the Bank at any time.

 

The PRA published Policy Statement 27/15 to implement the FPC's UK leverage ratio framework in December 2015. This confirms that a 3% minimum leverage ratio requirement plus systemic leverage buffers, where appropriate, applies to firms with retail deposits greater than or equal to £50bn from 1 January 2016 onwards. Therefore, the Bank does not currently have a minimum leverage ratio requirement. The FPC has confirmed that it will review its framework in 2017 with the possibility of extending the framework to all firms from 2018. If a minimum requirement is extended to include the Bank in 2018, it is anticipated that the Bank would not meet these minimum requirements. However, assuming a successful Capital Raising, the Plan targets a leverage ratio of 3% or greater by the end of the Plan.

 

Any formal introduction of current proposals from the Basel Committee to implement floors for Probability of Default (PD), Loss Given Default (LGD) and Credit Conversion Factor (CCF) in retail mortgages could also impact the planned allocation of capital to such assets through the life of the Plan.

 

2.2 Risks relating to the Bank's Credit Risk Capital Modelling Requirements

The Bank is not fully compliant with the Capital Requirement Regulations (CRR) provisions related to the use of an Internal Ratings Based (IRB) approach to modelling its credit risk capital requirements.

 

A review by the regulator in 2015 identified areas of non-compliance and inadequate procedures relating to use of the IRB approach requiring improvement and remediation to rectify under supervisory guidance. These areas involved a redesign of model risk policy, redevelopments of the Bank's IRB models and the strengthening of the overall control environment. In March 2016, the Bank received a communication from the PRA levying a CRR-related Pillar 2a capital requirement in the form of a fixed add-on in order to cover these risks. It is the Bank's objective, subject to successful completion of the remediation plan and PRA approval, to have the add-on removed at the end of 2017.

 

A failure to address CRR non-compliance within this timescale could potentially result in further regulatory action such that the Bank's permission to use an IRB approach could be removed, resulting in the use of a standardised approach to modelling credit risk. This could, among other consequences, expose the Bank to a material increase in the calculation of its RWAs and, given that many of the Bank's regulatory capital requirements are calculated by reference to the Bank's RWAs, there may be a consequent requirement to hold additional capital, the creation of an additional ICG deficit and/or a reduction in the Bank's CET1 ratio and an impact to the Bank's ability to meet its capital, ICG or MREL requirements.

 

Accordingly, there is a risk that the Bank would require more equity and other forms of loss-absorbing capacity beyond that contemplated by the Plan.

 

2.3 Optimum portfolio Risk Weighted Assets temporary adjustment

The Bank is seeking to enhance its credit modelling capability in a number of key portfolios due to the inherent weaknesses referred to in 2.2 above; and to meet PRA requirements. A major element of these enhancements to the existing models relates to how the Bank determines RWAs for retail secured mortgages.

 

In June 2013 the Bank initially assessed the impact of potential enhancements which drove a £1.0bn increase in the underlying RWAs calculated from the current models. The increase predominantly related to the Optimum portfolio and the £1.0bn adjustment had been included within the Optimum RWAs. This is referred to as a temporary adjustment.

 

Following the significant deleverage of the Optimum balances in 2015, the Bank judged it appropriate to reduce the temporary adjustment from £1.0bn to £0.3bn in line with the balance reduction in order to ensure that the Optimum RWAs were more reflective of the underlying credit quality of the reduced size of the portfolio. The Bank intends to remove the remaining £0.3bn of the temporary adjustment to the underlying RWAs shortly.

 

2.4 Risks Relating to Resilience and Recoverability of Critical IT Systems and Controls

Since early 2014, the Bank has run major programmes of IT remediation, including the migration of IT Infrastructure to an IBM managed service platform. Collectively these programmes have addressed a range of deficiencies in the Bank's IT estate including, notably, the inability to prove disaster recovery capability for all critical business processes. In Q1 2015 the Bank received written confirmation from the FCA that the lack of proven end to end disaster recovery capability constituted a breach of the FCA's Threshold Conditions 3.

 

As part of the remediation programmes outlined above, the Bank has built resilience into each component of its critical IT infrastructure, proving the Bank's ability to recover its critical services in the event of the failure of any individual component.

 

The Bank believes that this component-level proof of recoverability, taken in aggregate, delivers a reasonable level of recoverability from a major IT infrastructure failure, e.g. the loss of a data centre.

 

The migration of the Bank's mainframe and associated systems to an IBM managed environment (announced in January 2015) completed in February 2017. This has significantly improved the Bank's ability to test and demonstrate this recoverability of service. There will be further migrations during the next 12 months as the Bank completes its technology separation from The Cooperative Group.


Whilst IT remediation work will continue through 2017 and beyond, in light of the improvements made in IT risk and controls by the end of February 2017, and with particular reference to the migration referenced above, the Bank has received confirmation from the FCA that they consider the breach of the Threshold Condition has been remediated and the Bank to be compliant with Threshold Conditions.

 

For more information on the operational risk issues the Bank is exposed to due to historic lack of investment in systems and processes see 'Operational Risk' in section 3.4 below.

 

2.5 Risks Relating to Weaknesses in the Bank's Risk Management Framework (RMF)

A supervisory review of the Bank's RMF was conducted during 2015 and concluded that further work is required to fully embed the RMF across the Bank. To mitigate against the risk of non-compliance and the operational risks of weak RMF systems of control, since that review, the Bank has taken steps to enhance the RMF. Further work is required to fully embed the RMF to a consistent standard across the Bank. This continues to be a key priority for the Bank during 2017.

 

The PRA will continue to closely review the Bank's progress throughout the year. A failure to implement an RMF that addresses any remaining material deficiencies could potentially result in the Regulator taking further action and operational risks arising from any continuing deficiencies that may have a material adverse effect on the Bank's ability to implement its Plan.

 

3. Other Key Risks

The following pages outline the other key financial and non-financial risks to which the Bank is exposed. The crystallisation of any of these risks could result in an adverse effect on the Bank's business, operating results, financial condition, reputation and prospects. The Bank's RMF categorises these risks and comprises the Board approved segmentation of the risks that the Bank faces. See 'Risk Management' for the four main constituent 'Principal Risks' types in the RMF, how each Principal Risk is defined in the RMF and the risk taxonomy within the RMF (to which we refer in the table below).

 


Principal Risks - Definition

Why this is important

3.1

Credit Risk

The risk to earnings and capital arising from a customer's failure to meet their legal and contractual obligations.

 

 

Managing this risk is a fundamental part of what a bank does. The Bank's exposure to this risk is reducing as higher risk lending is deleveraged; however, as with all other banks, the Bank remains exposed to macroeconomic and market-wide risks such as issues with the housing market and interest rate changes.

 

3.2

 

Liquidity and Funding Risk

The risk that the Bank is unable to meet its obligations as they fall due or can only do so at excessive cost.

 

The Bank is reliant on its Retail deposit base as a major source of funding and given the relative size of the Bank's Retail deposit base as compared with other sources of funding the Bank is particularly exposed to liquidity risks, as a loss of confidence in the Bank by its customers may result in the loss of a high proportion of the Bank's funding.

 

The Bank monitors actions that it can take to mitigate unexpected retail outflows. These actions are monitored as part of the Bank's contingency funding plan and include (but are not limited to) the sale of secondary liquidity, bi-lateral wholesale funding actions and improving retail pricing.

 

There is a risk that press speculation and commentary may cause a loss in confidence which may erode the Bank's deposit base. The uncertainties and press speculation surrounding the Bank's future may increase this risk, although the Bank's deposit and customer base remained relatively resilient during the difficult and uncertain times of the Bank's 2013 recapitalisation. To mitigate against this risk, the Bank plans to monitor its deposit base and account transfers until the uncertainties dissipate.

 

On 15 February 2017, Moody's announced that it had downgraded the Bank's long term senior unsecured rating to Ca from Caa2 with a developing outlook. On 21 February Fitch downgraded the Bank's long term Issuer Default Rating (IDR) to B- from B with an evolving outlook. The Bank's current ratings are:

 


Long

Short

term

term

Moody's

Ca

Not prime

Fitch

B-

B

 

The Bank's current credit ratings continue to result in:

•  sub-investment grade ratings on the Bank's senior unsecured debt, in turn, leading to a significant reduction in the demand for these types of instrument;

•  a negative impact on the Bank's ability to access short term unsecured wholesale funding; and

•  heightened collateral requirements within some clearing systems.

 

3.3

 

Market Risk

Market risk is the risk of loss as a result of the value of financial assets or liabilities (including off balance sheet instruments) being adversely affected by the movement in market prices, interest rates or exchange rates. This loss can be reflected in the near term earnings by changing net interest income, or in the longer term as a result of changes in the economic value of future cash flows.

Macroeconomic uncertainty created as a result of political changes has introduced increased market risk volatility to which the Bank is exposed, although the eventual impact of the impending exit of the UK from the EU, the impacts of the new US presidency and forthcoming elections in the EU on market risk remain dependent on uncertain economic outcomes. This places further downward pressures on the Bank's forecast income and ability to generate sustainable capital strength.

 

The Bank's Treasury team manages interest rate risk. More information can be found in the risk management disclosures of the Bank's 2016 Annual Report and Accounts.

 

3.4

 

Operational Risk (including Legal Risk)

The risk of loss resulting from inadequate or failed internal processes, people and systems or external events.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operational risk levels remain elevated for the Bank due to a number of specific issues such as manual processes, legacy systems and processes for which remediation continues. In particular:

 

The Bank's IT system has been underinvested in for a considerable period of time.

The Bank has continued to improve its IT platforms during 2016 to address historic infrastructure and disaster recovery related issues. In the first quarter of 2017 a large proportion of the Bank's critical services will be supported by technology that will have been migrated to an IBM managed environment. The Bank has received confirmation from the FCA that they consider the breach of IT Threshold Conditions has been remediated and the Bank to be compliant with IT Threshold Conditions.

 

Notwithstanding these improvements in the Bank's core IT infrastructure, other aspects of the IT estate require further remediation, notably the desktop IT environment and the Bank's telephony systems. Furthermore some of the Bank's IT applications remain complex and therefore are susceptible to operational interruptions and inefficiencies.

 

Many of the Bank's business, operational, reporting and financial processes rely on significant manual processes and intervention which is inefficient and increases significantly the risk of errors in the Bank's data and financial reporting. The Bank's auditors have classified the weaknesses in the Bank's control environment as a 'pervasive risk to the audit' and 'in excess of what would be considered normal in the banking industry'. (See the 'Independent auditor's report to the members' section in this document). The extensive use of manual processes substantially increases operational risk. Until the controls remediation is complete, there is a significant risk that the Bank's financial statements or related disclosures may be restated (although this risk has decreased during 2016 due to improvements in the Bank's financial control and oversight process) and an increased risk that inadequate risk management could lead to exposures outside the Bank's risk appetite, unanticipated losses and regulatory censure.

 

The Bank's systems of control have been historically weak. In 2016 significant progress has been made to meet regulatory expectations in the overall effectiveness and embeddedness of the RMF and Model Risk governance frameworks. Focus through 2017 will be to ensure robust risk and control activities remain an integral part of the Bank's business as usual (BAU) activities. There is an increased awareness of the RMF across the Bank and work continues to further embed all elements. Key activity includes:

•  Further embedding of the RMF across the Bank through a normalisation process and collegiate working across all three lines of defence;

•  Completion of the Model Remediation Programme with particular emphasis on Capital Regulation Requirements (CRR) and Internal Ratings Based (IRB) and IFRS 9 model development and approval; and,

•  Focus on the development of Financial Reporting controls through further investment, reduction in manual interventions and automation of key activities.

 

The Bank is becoming increasingly dependent on outsourcing contracts and partners for its critical infrastructure and operational capability, often at significant expense.

 

The Bank is exposed to the risk that any outsourcing arrangements are not properly scoped by the Bank in determining business requirements; that the Bank or the supplier may default on or otherwise seek to avoid its contractual requirements; that the outsourcing is not properly managed by the Bank or delivered upon as expected by the outsourced provider on an ongoing basis.

In addition if any of the Bank's key outsourcing partners of crucial services cannot or will not continue to provide the outsourced functions and services for a sufficient time and with provision of adequate assistance to enable transfer to an alternative provider, then the Bank may face significant disruption to its services and functions, reputational damage and possible regulatory scrutiny, which may adversely affect the Bank's operating results and financial condition.

 

The Bank is in the process of separating from The Co-operative Group. Through 2017 and beyond the Bank will continue to depend on The Co-operative Group to provide a number of services including critical IT services, personnel, and assets and to on-supply certain services, including data and assets, from third party suppliers. The Co-operative Group may terminate certain critical IT services on twelve months' notice and the Bank is in negotiations for the transfer of intellectual property in certain IT applications currently owned by The Co-operative Group. The Bank is progressively migrating to alternative services providers and contractual arrangements, notably via the migration of the Bank's core technology to an IBM managed environment, but this ongoing separation project is complex and may be more costly and take more time than currently contemplated. Furthermore the replacement arrangements may be more costly than the current arrangements with The Co-operative Group. The Bank also has significant counterparty exposure to The Co-operative Group.

 

The Bank faces legal, financial and reputational risk where legal proceedings are brought against it, including as a result of the Bank's day-to-day business activity or encouraged by adverse findings of various investigations into events and activities at the Bank. Liability for damages may be incurred by the Bank where third parties are harmed by the conduct of the Bank's business. The Bank may also face legal, financial and reputational risk if proceedings brought by it against customers or third parties, or third party proceedings or enforcement actions involving other banks, are determined adversely to the interests of banks generally or the Bank. These adverse determinations, for example, concerning the enforcement of mortgages and or other products, or operational practices or documentary deficiencies, may have an adverse effect on the Bank's assets, funding facilities, operating results and financial condition.

 

Fraud risk: As with other banks, reflecting the increased use of technology in financial services, the Bank and its customers are at a risk of cyber-attacks including attacks designed to overload the Bank's systems. These risks are accentuated as the Bank increasingly digitalises its products, services, key functions and distribution channels and as cyber-attacks become more sophisticated and prevalent. The Bank remains at the risk that any cyber-attack may result in temporary lack of operational availability of the Bank's systems to its employees and/or customers. The Bank continues to manage fraud risk including cybercrime within risk tolerances to manage any resultant losses and to comply with all relevant legal and regulatory requirements.

 

3.5

 

Reputational Risk

Reputational Risk is the risk of damage to how the Bank's reputation, brand or image are perceived by its internal or external stakeholders as a result of its conduct, performance, or the impact of operational failures or other external issues.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Bank considers that its reputation as an ethically led organisation is critical to the success of the Plan and actively seeks to manage and mitigate the risks that may impact its reputation. There is a risk that regulatory findings and investigations may adversely affect the Bank's reputation. In addition, the Bank's Plan contemplates significant cost savings including branch closures and staff reductions, which increase this risk.

 

The Bank continues to use the Co-operative name and brand and therefore carries the risk that its brand may be damaged as a result of matters affecting The Co-operative Group or other co-operatives. The Co-operative Bank trademark belongs to the Bank. In certain circumstances the Bank's right to use the term 'co-operative' could be challenged or removed. The Secretary of State for Business, Energy and Industrial Strategy may direct the Bank to change its registered name if, in their opinion, it gives so misleading an indication of the nature of its activities as to be likely to cause harm to the public. Further, the FCA has the power to prevent the use of the term 'co-operative', or to take other action regarding the Bank's branding, if the FCA considers this desirable to protect consumers, to promote competition in the interests of consumers or to protect the integrity of the UK financial system. A loss of support from key stakeholders for the Bank's continued use of the term 'co-operative' may result in a risk that these authorities could look to exercise their powers leading to legal, financial and reputational risk.

The Bank manages the risk through its actions and commitment to the established values of the co-operative movement, as demonstrated by the embedding of co-operative values and ethics in its articles of association and its Ethical Policy. This risk may increase depending on any changes in the ownership of the Bank resulting from any sale of the Bank or Capital Raising; particularly should The Co-operative Group see its shareholding decrease and as a result reduce its support for the Bank's continued use of the term 'co-operative'.

 

The Co-operative Group also to some extent links its support for the Bank maintaining the term 'co-operative' to the Bank's involvement in The Co-operative Group's membership scheme. The Bank's broader participation in that membership scheme has been under discussion, which discussions The Co-operative Group has put on hold while it awaits further clarity on the future ownership of the Bank. Should these discussions not re-start or should the Bank not participate in the membership scheme, it may increase the risk of a loss of support from The Co-operative Group for the Bank's continued use of the term 'co-operative'.

 

The Bank and The Co-operative Group entered into branding co-existence principles in 2013 and had been negotiating a more detailed agreement which has not been finalised. The Bank continues to liaise with The Co-operative Group regarding use of trademarks and intellectual property relating to the brand where some trademarks used by The Co-operative Group are owned by the Bank and vice versa. Further, the Bank has applied to register 'The Co-op Bank' as a trademark. The Co-operative Group has objected to that registration, and this forms one of the matters on which the Bank continues to liaise with The Co-operative Group. If consensual outcomes are not agreed, this could lead to potential legal, financial or reputational risk for the Bank.

 

3.6

 

Strategic and Business Risk

Strategic Risk is defined by alignment to the CRD IV definition of Business risk, as any risk to a firm arising from changes in its business, including: a) the acute risk to earnings posed by falling or volatile income; and (b) the broader risk of a firm's business model or strategy proving inappropriate due to macroeconomic, geopolitical, industry, regulatory or other factors.

 

The principal risks and uncertainties relating to the Bank's Plan and current strategy are summarised in section 1 above.

 

3.7

 

People Risk

People Risk is defined as the risk associated with inappropriate employee behaviour, inadequate resource (people, capability and frameworks), resulting in customer or financial detriment, and/or legal or regulatory censure.

 

Retention of Bank personnel remains a significant risk for the Bank and is currently heightened by the inability to use variable pay to reward performance, budgetary constraints limiting changes to fixed pay, headcount reductions and ongoing pressure on cost reduction.

 

Whilst employee engagement levels remained relatively stable over the course of 2016, employee confidence in the future of the business declined. Reassuringly the significant majority of the employees believe in the Bank's values and are therefore willing to make an increased effort to support the Bank, but do not feel involved. Staff retention and engagement will be a significant challenge for the incoming executive team.

 

The Bank began a number of key initiatives during 2016 to tackle some key issues relating to people risk. The Bank's Culture Programme sought to improve colleague engagement, reinforcing the Co-operative Bank Values and Culture and embedding these into employee policies and processes. The Emerging Talent strategy advanced in 2016 with the introduction of the summer internship programme, apprenticeships and the continuation of the graduate scheme. The Bank has made considerable progress in strengthening its talent profile and senior level succession planning has made considerable improvement, although ongoing structural changes will impact on succession planning strength.

 

 If senior executives or management leave the Bank earlier than planned, the Bank may struggle to replace them with appropriate and sufficiently skilled candidates in a timely fashion, exposing the Bank to operational disruption and potential delay in essential activities necessary for the Plan to be successfully delivered. The requirements of CRD IV affecting variable remuneration may drive higher fixed costs or impact recruitment and retention of staff until the Bank is compliant with its ICG and PRA buffer.

 

3.8

 

Regulatory Risk

Regulatory Risk is defined as the risk that the Bank and subsidiaries breach the letter and spirit of relevant laws, regulations, codes of practice or standards of good market practice.

 

Along with the wider banking industry, the Bank must comply with multiple regulatory changes which may add complexity to an already difficult technology, operational and prudential change programme.

 

There is also a risk that, both foreseen and unforeseen, changes to regulatory requirements affect the Bank's ability to successfully implement its Plan or that the acceptance by regulatory authorities of the Bank's plan to address the various ways in which the Bank is currently non-compliant and which is essential for the Bank to continue to operate, is withdrawn. Changes to regulatory requirements could result in additional compliance costs and diversion of management time and resources.

 

The principal risks arising from the regulatory position of the Bank, including the Bank's compliance with ICG and CRR regulatory requirements, including CRR credit risk modelling requirements, are described above in this Principal Risks and Uncertainties section.

 

The Bank remains exposed to increased regulatory scrutiny, resource drain, damages, fines and costs, adverse publicity, reputational damage and litigation claims as a result of (a) the eventual outcome of remaining investigations into the events which gave rise to the 2013 capital raising (being remaining investigations into former senior management, the role of the Bank's former auditors for the period up to and including the Bank's 2012 Annual Report and Accounts, and the actions of relevant authorities (regulators and government)) in the event that any of these impact on the Bank itself or (b) any future regulatory investigations, enforcement actions and remediation programs.

 

The financial services industry continues to be the focus of significant legislative and regulatory change which has and could continue to impose operational restrictions on the Bank, increase the Bank's costs and/or capital requirements and/or otherwise materially adversely affect its business, operating results, financial condition and prospects.

 

Money-Laundering Risk

The Bank remains fully committed to supporting international and domestic efforts to combat money laundering and the funding of terrorist and criminal activity, preventing the illicit use of the Bank's products and services and to meeting the Bank's legal and regulatory obligations in full. While a remediation programme is substantially complete, more work is required to be done in this regard.

 

Competition Law Risk

In addition, the Competition and Markets Authority (the CMA) published its final report on its market investigation into retail banking on 9 August 2016. The financial and other impact of the remedy package on the Bank is still under review and the impact on the wider industry as a whole is still uncertain. However, the remedies announced will require significant change, cost and complexity to be managed in a relatively short timeframe, particularly in the development and implementation of an open Application Programming Interface (API) standard for banking, which could adversely affect the Bank's business, operating results and financial condition.

 

3.9

 

Conduct Risk

Conduct Risk is defined as the risk that the Bank's behaviours, offerings or interactions will result in unfair outcomes for customers.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The Bank is exposed to the inherent risks relating to the mis-selling of financial products, acting in breach of regulatory principles or requirements and giving negligent advice or other conduct determined by the Bank or the Regulators to be inappropriate, unfair or non-compliant with applicable law or regulations. Any failure to manage these risks adequately could lead to further significant provisions, costs and liabilities and/or reputational damage. The Bank's approach to provisions for historic mis-selling issues, such as PPI and packaged accounts, is based on the views and requirements of the Regulators and on current and estimated complaint volumes. Any change in the Regulator's current approach or complaint volumes could have a material impact.

 

During 2015, the FCA proposed a time bar on PPI claims (which of itself could be subject to judicial challenge) and a dedicated marketing campaign to consumers as to their right to reclaim PPI. The FCA initially proposed a time bar to June 2019 and a revised approach to redress calculations in relation to undisclosed commission rates will be adopted. The FCA has recently announced that the time bar will become effective from 29 August 2019 and the Bank has taken this into account in its provisioning. As at 31 December 2016, a provision of £90.4m (December 2015: £87.0m) had been recorded in respect of potential customer redress and costs relating to past sales of PPI. Forecast future complaint volumes are difficult to predict and may increase, remain constant or decline more steadily due to the proposed time bar, FCA communications campaign and the introduction of the new online PPI complaint system which makes it easier for consumers to contact the Bank.

 

The Bank has substantially completed its programme of a structured risk based assessment of products and provisions, of which the primary focus was the discovery and remediation of existing and new conduct and legal issues. The Bank is currently investigating a number of potential conduct issues including mortgage systems configuration. As at 31 December 2016, the Bank has made a provision of approximately £20.1m for conduct issues in relation to miscalculation of monthly mortgage payments resulting from the misconfiguration of mortgage systems. This provision includes the cost of delivering redress to customers.

 

The current overall conduct provision includes provisioning for the currently estimated redress and delivery costs of a number of conduct issues that are not considered material for specific provision. These issues include products or services relating to bank charges, auto-capitalisation issues, student and certain other overdrafts and loan early settlement charges. In addition, the Bank holds a provision of £8.1m for issues incurred but not yet identified (IBNI) for the year ended 31 December 2016. While progress has been made in resolving conduct issues, there is a risk that the Bank's provisions - whether in aggregate, specific or IBNI - are insufficient, or that already identified issues or further issues may require significant further or new provisioning, and/or significant redress and remediation costs. The Bank is also exposed to the risk that changes in regulation and enforcement policy may give rise to further conduct issues emerging. No assurance can be given that further issues will not be identified, or that any such further or already identified issues may not require new or further provision, or that changes in regulation may not give rise to further conduct risks emerging.

 

As well as PPI, the Bank continues to monitor developments in product related areas that attract increased focus from regulators, the courts and the FOS, such as early repayment charges in both commercial and secured lending and variation of certain product terms and conditions. Changes in the approach to any of these issues in the market could adversely affect the Bank.

 

The Bank initiated a redress programme in respect of various breaches of mortgage conduct of business rules and was the subject of a skilled persons review into potential detriment to its mortgage customers arising from poor arrears handling. The Bank has substantially completed the recommendations from this review and has implemented enhanced policies and processes which are designed to deliver improved customer outcomes. The outcome of the final review is not yet finalised but the risk of further enforcement action by the FCA is considered to be largely mitigated.

 

The Bank has largely completed the remediation of historic breaches of the Consumer Credit Act (CCA), including the payment of appropriate redress to customers. While the remainder of the remediation work is undertaken some current loans will require further remedial steps to ensure they remain compliant. If this work is not fully completed or if other breaches of the CCA emerge then there is a risk of non-compliance with the technical requirements of the CCA which can include interest and default charges paid by a customer in prior periods being required to be refunded and the customer agreement not being enforceable by the Bank without a court order until the breach is remedied. In certain circumstances, the Bank may be unable to rectify the historic issues accurately or at all, which may lead to continuing non-compliance with the CCA.

 

3.10

 

Pension Risk

The Bank will take appropriate actions to manage pension risk exposure (deficit recovery contributions and Individual Capital Guidance) in its capital and earnings objectives.

 

 

 

 

 

The Bank is a participating employer in Pace, which has both an active defined contribution section and a closed defined benefit section. The Pace Scheme is not currently sectionalised and operates on a 'last man standing' basis, with a risk that the Bank's obligation to Pace would therefore increase significantly if another large employer in the scheme (the largest of which is The Co-operative Group) were to become insolvent. The Defined Benefit section of Pace is not further sectionalised. To mitigate this risk, the Bank is now in consultation with The Co-operative Group and the Pace Scheme Trustee with the aim of separating its liabilities in the scheme from those of other participating employers or exiting the scheme and apportioning its liabilities to other participating employers.

 

At present, there is uncertainty over the Bank's share of Pace liabilities, which the Bank is expecting to resolve as a part of the separation discussion. However, if sufficient information is available to the Bank to identify its share of the underl