Pending bank acquisitions by the two largest U.K. building societies are set to bring more customers within a mutual business model. There is a long history of mergers between building societies, but it is unusual and bold for them to acquire banks. S&P Global Ratings believes that the transactions reflect competitive pressures that midsize financial institutions face in the commoditized U.K. residential mortgage and retail savings markets. If executed well, these acquisitions of complementary businesses would enable the buyers to deepen and broaden their franchises and maintain solid balance sheet profiles.

Like bank peers, building societies' current performance benefits from higher interest rates and benign credit quality. That said, the sector does not aim to maximize earnings and instead prioritizes delivering sustainable value to customers. The challenge for building societies is to compete effectively with banks while distinguishing themselves from those same banks through differentiated service, products, and pricing. Building societies have proven ability to adapt to economic, technological, and regulatory changes and are set to remain a material presence in U.K. financial services.

Bank Acquisitions Are Set To Expand The Mutual Frontier

Nationwide Building Society (A+/Stable/A-1) and Coventry Building Society (not rated) announced transformative, in-market acquisitions in the past two months:

• In March 2024, Nationwide and Virgin Money UK PLC (VMUK; BBB-/Watch Pos/A-3) announced that they had agreed the terms of a £2.9 billion cash acquisition of VMUK by Nationwide (see Nationwide Building Society Affirmed At 'A+/A-1' After Announcement Of Virgin Money UK Acquisition; Outlook Stable, published on March 21, 2024). The deal is subject to regulatory and VMUK shareholder approvals.

• In April 2024, Coventry and The Co-operative Bank Holdings Ltd. (Co-op Bank; not rated) announced that they had agreed the terms of a £780 million cash acquisition of Co-op Bank by Coventry. The deal is subject to regulatory approval. Co-op Bank's name references that it was formerly part of the co-operative movement and its acquisition by Coventry would see it return to the mutual sector.

Without shareholders to please, building societies can afford to take a longer-term approach to strategic and financial planning than bank competitors. The acquisitions by Nationwide and Coventry appear to be considered responses to challenges facing their competitive positions in retail banking. Specifically, we think changes in regulation and technology increase the importance of economies of scale in price-competitive mortgages and savings, and the acquisitions enable the buyers to deepen their presences in these segments. For example, in terms of market share, the VMUK transaction would propel Nationwide into clear second place in mortgages and cement its existing second position in the retail savings market.

For both acquisitions, the large overlap between the acquiring and acquired businesses should mitigate execution risks. Still, there will inevitably be prolonged integration processes in which the buyers will be more inwardly focused than most competitors.

The acquisitions also provide Nationwide and Coventry with entry points into complementary product segments that moderately diversify their revenue and funding. Buying VMUK will bolster Nationwide's franchise in current accounts and credit cards and enable it to provide business loans. Nationwide has long harbored ambitions to enter the business lending market but cancelled its plan at the onset of the COVID-19 pandemic. Somewhat similarly, Coventry disclosed that the Co-op Bank deal will enable it to extend its retail current account proposition and introduce business deposit products.

In terms of balance sheet size, Nationwide is in the same ballpark as the largest ring-fenced banks and the VMUK acquisition will add further scale. The other building societies rank further behind (see chart 1).

Chart 1

Higher Interest Rates Benefit Banks And Building Societies Alike

Improved net interest margins and low credit losses currently benefit the earnings of both banks and building societies. Markets have tempered their expectations on the pace of interest rate normalization and we expect the Bank of England (BoE) to cut rates gradually starting in August 2024 (see Economic Outlook Q2 2024: The U.K. Is Slowly Turning A Corner, published on March 26, 2024). Strong mortgage competition and deposit migration to higher-paying accounts have exerted pressure on retail lenders' margins since mid-2023 but these effects are now stabilizing. Improving structural hedge yields should act as a growing tailwind to income over the next two years.

Unlike banks, building societies do not seek to maximize profits from members and instead aim to generate sufficient earnings to maintain robust solvency and leverage metrics. For example, amid the cyclical upturn in earnings and slow credit growth, Nationwide introduced "fairer share" payments last year to distribute a share of its profits directly to eligible members. These payments supplement the value that building societies routinely aim to deliver to members through customer service and product pricing. Nevertheless, building societies' disciplined strategic focus enables them to deliver solid risk-adjusted profitability comparable to ring-fenced banks (see chart 2). Returns on risk-weighted assets are influenced by each lender's regulatory approach (for example, whether it applies standardized or model-driven capital charges) and the extent of non-banking activities such as property services.

Chart 2

Building societies' focus on price-competitive mortgages and savings compresses their net interest margins compared with more diversified banks (see chart 3). The major banks' dominance of low-cost retail and corporate current accounts provides a particular advantage over building societies. Banks also have proportionally larger exposures to higher risk, higher margin lending such as unsecured consumer credit and corporate loans. A higher-for-longer interest rate environment would provide support to margins in 2024.

Chart 3

Operating efficiency is important for building societies to remain price-competitive with banks, and their metrics compare well (see chart 4). Mortgage administration is generally less expensive over the life of the product than corporate lending and unsecured consumer credit, in which banks are more active. That said, building societies' differentiated customer proposition adds to their fixed costs in some areas. For example, building societies' 38% market share of branches is roughly double their share of mortgages and retail savings because they made a conscious decision to slim their networks at a slower pace than banks. This reflects the higher priority they typically place on maintaining a community presence.

Chart 4

For many years, technology and regulatory compliance have been growing components of lenders' costs, and smaller building societies face a tougher task than larger competitors in absorbing these investments. For example, the U.K. regulator applies strict demands on consumer protection, firms' operational resilience, and cyber risk management. Economies of scale have driven the long-term consolidation of the building society sector and there may well be further mergers, particularly when the revenue and credit environments weaken.

Large Building Societies Maintain Substantial Capital And Bail-In Buffers

Capital and leverage metrics are often a credit strength for building societies because they typically operate with larger buffers over minimum regulatory requirements than bank peers (see chart 5). Nationwide and Coventry will fund their pending acquisitions from existing resources and negative goodwill will partly mitigate the dilutive impact of the transactions on their capital ratios. Balance sheet reserves provide the vast majority of building societies' common equity Tier 1 (CET1) capital and the sector has a little less capital flexibility than banks, in our view. However, they can issue core capital deferred shares to supplement CET1 resources and they are also active in Additional Tier 1 and Tier 2 markets.

Chart 5

Minimum leverage ratio requirements apply to U.K. banks and building societies with over £50 billion of retail deposits. Due to its low-risk balance sheet dominated by mortgages and liquid assets, the leverage ratio is the binding constraint on Nationwide's capital position rather than risk-weighted ratios. The same will be true of Coventry and Yorkshire Building Society when they cross the £50 billion threshold, which is likely to happen soon because each held just over £47 billion of deposits at year-end 2023.

Bail-in is the Bank of England's preferred resolution strategy for the five largest building societies and their minimum requirements for own funds and eligible liabilities (MREL) therefore stand materially above their minimum capital requirements. Since building societies cannot be owned by holding companies, they issue senior non-preferred debt to strengthen MREL resources alongside regulatory capital (see chart 6). In our rating methodology, we recognize Tier 2 and senior non-preferred debt as additional loss-absorbing capacity that can result in rating uplift if the available resources exceed our thresholds.

Chart 6

Smaller building societies do not have MREL requirements and would currently face liquidation if they became non-viable and there was no buyer for all or part of their operations. The BoE's first resolution action under its enhanced intervention powers involved Nationwide acquiring most of Dunfermline Building Society's assets and liabilities in 2009, with the remainder of Dunfermline's balance sheet entering administration. A recent U.K. government proposal recommended empowering the BoE to obtain capital contributions from the deposit guarantee scheme to cover the costs of transferring a failing non-systemic bank or building society to a bridge bank or a private sector purchaser. If adopted, this change would give the BoE greater flexibility in handling a small lender that became non-viable (see U.K. Proposal Would Unlock Resolution Funding For Small Banks, published on March 5, 2024).

Benign Asset Quality Despite Tepid Economic Growth

Building societies' focus on residential mortgage lending has kept their credit loss charges at low levels compared to the ring-fenced banks (see chart 7). Although U.K. economic growth is weak and there was a technical recession in the second half of 2023, household debt affordability is supported by low unemployment and robust real wage growth. Mortgage arrears are rising from the mid-2022 cyclical low point as many borrowers have experienced a material increase in monthly repayments after refinancing. However, arrears remain relatively low in absolute terms and borrowers' repayment capacity was stress tested at origination at higher interest rates than current market pricing. House prices and mortgage demand weakened on the back of interest rate hikes, but housing market activity has improved in recent months as inflationary pressures eased. We project that U.K. systemwide impairment rates on mortgages will remain below five basis points in 2024-2026 (see Unsecured Consumer Lending Will Drive U.K. Banks' Credit Losses To £4.4 Billion, published on April 18, 2024).

Chart 7

Building societies report lower impaired loans and mortgage arrears than banks due to their stronger focus on prime, owner-occupied, well-collateralized lending (see chart 8). Stage 2 assets--those for which credit risk has increased significantly since origination--are difficult to compare between lenders due to inconsistent triggers to move balances from stage 1. U.K. lenders' stage 2 balances are relatively high compared to banks in other European countries, but the vast majority of these loans are fully performing.

Chart 8

Solid Funding And Liquidity Positioning

Building societies' established retail deposit franchises ensure solid funding positions, similar to ring-fenced bank peers (see chart 9). Building societies' focus on retail savings, including term products, over transactional accounts may be supportive for deposit stability under stress. Building societies are required by law to source at least 50% of their funds from customer savings and operate comfortably above this threshold. A legislative change is currently in progress that would maintain the 50% limit but exclude from the calculation MREL issuance, sale and repurchases of liquid assets, and borrowing from the BoE in times of stress. If passed, this measure would give greater flexibility to building societies and establish a more level playing field with banks, but it looks unlikely to alter their funding profiles materially.

Chart 9

Building societies' regulatory funding and liquidity ratios are robust and well in excess of minimum regulatory requirements (see chart 10). In some cases, liquidity coverage ratios are at temporarily elevated levels due to upcoming repayments of borrowing from the BoE's term funding scheme with additional incentives for small and midsize enterprises (TFSME).

Chart 10

Building Societies Are Here To Stay, But The Sector Will Continue To Evolve

The U.K. building society sector has a long history, stretching back more than two centuries. In an era when social credentials matter more than ever, building societies' mutual values and purpose provide a distinctive alternative to banks. Nevertheless, they operate in a competitive and innovative market and must move with the times to remain relevant. While the long-term effects of new technologies continue to play out, building societies have so far managed to invest sufficiently to sustain an appealing customer proposition, realize cost efficiencies, and ensure operational resilience. We think the sector is well-placed to continue adapting to change and remain an important part of the U.K. financial services landscape.

Related Research

• Unsecured Consumer Lending Will Drive U.K. Banks' Credit Losses To £4.4 Billion, April 18, 2024
• Economic Outlook Q2 2024: The U.K. Is Slowly Turning A Corner, March 26, 2024
• Nationwide Building Society Affirmed At 'A+/A-1' After Announcement Of Virgin Money UK Acquisition; Outlook Stable, March 21, 2024
• U.K. Proposal Would Unlock Resolution Funding For Small Banks, March 5, 2024
• Historical Virtues Do Not Shield European Cooperative Banking Groups From Disruption, Sept. 14, 2020