Co-op Bank to fill £1.5bn hole

The Co-operative Group has reached agreement with the City regulator that the hole in the Co-op Bank is around £1.5bn, I have learned.

This shortfall in capital, the funds all banks have to hold as a protection against losses, is near the upper end of expectations. An announcement is expected early Monday.

The Co-op will raise much of the needed capital by what is known as a "bail in", converting loans to the group into shares which will be listed on the London Stock Exchange.

This contrasts with the many bank "bail outs" of 2007-8, in which desperate banks were kept alive by injections of funds from the public sector.

With a minority of Co-op Bank's future shares tradeable on the Exchange, the Co-op Bank will begin to look more like a conventional bank and less like a mutual - although it will still be controlled by the mutual Co-op Group.

This forced conversion of bonds into equity is likely to be hailed by the regulator, the Prudential Regulation Authority, as an important precedent - because it will demonstrate that banks in serious difficulties can be rescued without recourse to money from taxpayers.

For the past few weeks, the Co-op has been in tense negotiations with the PRA over the future of its bank, after it belatedly recognised that it faced huge losses on commercial property loans and its debt was downgraded to junk by the ratings agency Moody's.

Many of Co-op Bank's loss-making loans were acquired when it merged with the struggling Britannia Building Society in 2009.

Although depositors in the Co-op will be relieved that their bank is being rescued, the nature of the rescue will be highly controversial - because it may well be seen as the Co-op Bank moving away from being a pure mutual.

As I have already mentioned, some of its bonds, or loans to the bank, will be converted into shares, which will be listed on the London Stock Exchange - although the precise terms and scale of this debt-for-equity swap will be subject to negotiations between the bank and the investors which own the bonds.

The Co-op Group is expected to remain the majority and controlling shareholder in Co-op Bank, but a significant minority will be held by commercial investors.

What is unclear at the time of writing is whether the debt-for-equity swap will apply only to holders of subordinated debt, which is the debt perceived as riskier (in the jargon it is known as Tier 2 capital). There is £1.1bn of this subordinated debt.

However, it is possible that some holders of so-called senior debt will also be asked to convert a portion of their loans into shares.

That would represent a much more radical solution.

If that were to happen, British banks in general might find it more expensive to borrow by issuing senior debt.

Debt called "senior" is supposed to be less risky than subordinated debt, because in theory it is the last category of debt to be hit by losses when a bank or other borrower gets into difficulties.

As disclosed earlier this year, the Co-op Bank is also raising capital by selling its insurance operations and shrinking so-called non-core operations.

The performance of the City regulator will be seen as mixed in the Co-op case.

On the one hand, it may have succeeded in propping up the bank at zero cost to the public sector, which would be seen as a good thing.

But it has also been widely criticised for failing to see how weak the Co-op Bank had become till earlier this year.

Today, regulators concede that the Co-op Bank's previous management had done a poor job assessing and managing the risks of acquiring the Britannia Building Society.

But the PRA and the Treasury did not stop that same Co-op management trying to take on an even bigger challenge when it spent years negotiating to treble the size of the bank by buying 631 branches from Lloyds.

It abandoned the takeover of Lloyds branches in late April, and Co-op recruited a new chairman and chief executive of the bank in the past few weeks.