Co-op set to become big banker

What follows was originally published at 9.52am. It has been slightly overtaken by events (see update at bottom), but the substance remains relevant.

Tomorrow it is probable that a little bit of British financial history will be made, in that quite a big chunk of the British banking industry may be put on a path towards mutual ownership.

The board of Lloyds is likely to decide that its preferred bidder for the chunk of its business which the European Commission is forcing it to sell - and which has been nicknamed Verde - is the Co-operative Banking Group.

If that happens, and I'll explain in a moment why that's likely, it would represent the first time in more than 20 years that the size of the mutually owned banking industry has actually grown - following year after year of demutualisation, that saw the Halifax, Abbey National and Northern Rock, inter alia, all becoming public companies, for better or worse (often worse).

As it happens, Verde is not far off the size of Abbey National (which was eventually swallowed by Santander, after it embarrassed itself financially as a listed business).

What Lloyds is selling is a business with an estimated 4.6% of the British current account market, 632 branches, £36bn of deposits, and about £47bn of mortgages and loans.

Or to put it another way, this is a business large enough to be visible on more-or-less all our high streets.

There are two remaining bidders for Verde. One is the Co-op.

The other (and first) bidder is NBNK, the company set up by Peter Levene with the explicit purpose of buying a bank. It's run by Gary Hoffman, the former Barclays executive who rehabilitated Northern Rock for the government.

Now as I explained in late September, NBNK has a significant regulatory disadvantage in the auction.

Its bid of £1.5bn would crystallise a loss for Lloyds and its shareholders of an eye-watering £2bn, whereas an equivalent bid from the Co-op would crystallise a loss for Lloyds of around half that.

Lloyds is being forced to sell off part of its business

The reason is that as a new kid on the block, NBNK would be given what's known as "standard status" by the Financial Services Authority, whereas the Co-operative - with its longer history and considerable size in financial services - already has so-called "advanced status".

That means Lloyds would have to inject considerably more capital into Verde, before sale, if it went to NBNK than it would have to do if Verde went to the Co-op.

Here are the numbers: Lloyds would have to endow Verde with £3.6bn of capital, if NBNK were owner, but only £2.5bn of capital if Co-op were owner.

On that basis, the fiduciary duty of Lloyds' board is unambiguous: it would have to sell to the Co-op, since the men in white coats would presumably cart off the directors if they needlessly foisted an unnecessary extra £1.1bn of losses on Lloyds' owners.

Now it is of course possible that NBNK will be able to provide some kind of comfort to Lloyds' directors that it is likely to receive advanced status relatively quickly - and in those circumstances it would repay the surplus capital back to Lloyds.

But banking sources tell me it is highly improbable that - in these risk-averse times - the FSA will give a guarantee that NBNK would receive advanced status on any set timetable.

And there's another important consideration for Lloyds' board.

Lloyds will warrant that a few million customers will move with their branches to the new owner. But it can't force customers to transfer their accounts.

So if vast numbers of the customers who currently bank in Verde branches decided they were furious that Lloyds is dumping them on a new owner, and refused to bank with the new owner, there would be a massive logistical and financial headache for Lloyds.

Now common sense suggests those customers will be less uneasy about moving if the new owner is an organisation of which they've heard and which has been around for many decades, rather than a brand new outfit that's been around for a few months and currently has no presence in banking.

To put it another way, what bankers call "the execution risk" in the deal looks less in a Co-op takeover than for an NBNK takeover.

On the other hand, NBNK is confident that its IT systems skills - terribly important in any bank acquisition - are superior to the Co-op's.

What does all this tell us?

First that it is incredibly difficult to stimulate competition in banking, because of the regulatory and cultural obstacles faced by any start-up.

Second that it would be pretty odd if Lloyds' board doesn't tomorrow confirm that the Co-op is its preferred bidder.

Update 1434: Sorry, I got my timing wrong. While I was at lunch (talking about the woes of the High Street with a supermarket boss, if you must know) Lloyds announced that Co-op has already been chosen as the preferred bidder for Verde. Everything else I posted this morning stands.

Also, as I mentioned was likely last week, Lloyds' board has also decided that Antonio Horta-Osorio has made a full recovery, and can return to his job as the bank's chief executive in January.

Update 1446: The combination of Verde and the Co-op would create quite a chunky banking group, with a projected 7.6% share of the current-account market. This is greater than the 6% threshold identified by the Independent Commission on Banking as the necessary market share for a viable new competitor to the big banks.

Or to put it another way, the combination of Verde and the Co-op could - just perhaps - give RBS, Barclays, HSBC, Santander and even Lloyds a bit of a run for their money.