Mind-set and capacity to invest in digital transformation will be essential to remaining competitive

As with their commercial bank peers, cooperatives are facing unprecedented challenges and their unique organizational and ownership structure will not necessarily save them from demise. S&P Global Ratings believes their survival will depend on how their business and operating models adapt to changed client preferences and competitive trends in the digital age.

We expect our ratings on most groups to continue to be buttressed by their focus on long-term stability over short-term returns, and typically high capital levels. However, a number of poorly managed and failed or restructured cooperatives across Europe testify that single cooperatives are not immune from irrational exuberance elsewhere in the industry and associated profitability pressure, particularly if coupled with low sophistication of risk and governance standards. That said, most troubled European cooperative banks have been supported by their groups, highlighting the robustness of their support mechanism and the values of the cooperative brand. This solidarity is a core strength to our view of cooperatives' creditworthiness and contributes to their stability during downturns. Additionally, some cooperative groups have created substantial bail-in buffers to enable recapitalization if they fail.

In this report we highlight selected rated European cooperative and mutual groups, including credit unions, building societies, and other cooperative financial institutions, whose main feature is that as "members," its customers control the capital on the principle of one member = one vote. Credit cooperatives were founded during the 19th century to improve access to finance for their members, who would otherwise have had limited access to finance at reasonable rates. Today, one might question their "raison d'etre" in the dramatically changed market. For example, the difference between the products offered by cooperatives and commercial banks in Europe has broadly vanished due to high commoditizing and accessibility of banking services. While we believe local presence and expertise will remain a competitive edge for cooperative groups, these historical virtues alone will no longer be sufficient to outshine the more efficient and agile services providers. Client experience and satisfaction will determine the stability of the client base. As such, a correct mind-set and capacity to invest in digital transformation and client experience to keep up with commercial challengers will be essential to remaining competitive.

Table 1

From market leader to a small niche bank

The European Association of Co-operative Banks recognizes 27 cooperative groups in Europe (excluding the U.K.). These groups operate about 2,800 banks locally, serving 209 million customers. These are mainly households, small and midsize enterprises (SMEs), and the public sector. Europe's cooperative banks represent 84 million members and have an average market share in Europe of about 20% (up from 17% around 10 years ago, mainly boosted by French groups' strong growth).

Market share differs widely by country. In France, Germany, Netherlands, Finland, and Denmark, cooperative banks' market share in loans ranges between 25% and 45%. By far the largest cooperatives in Europe are the French and the German groups. In France, two of the three cooperative groups are classified as Global Systemically Important Banks (G-SIBs; BPCE and Groupe Credit Agricole), reflecting their size and importance.

In the U.K., the cooperative sector primarily comprises 43 building societies, which focus on residential mortgages and household savings. Their overall share of outstanding balances in the mortgage market was 23% at year-end 2019. The cooperative sector plays a smaller part in Spain, Portugal, Switzerland, Norway, and Sweden. In Spain and Portugal, it accounts for no more than 5% of the market. In Norway and Sweden, the cooperative sector no longer exerts an important role.

In some markets, for example the U.K., some cooperatives have taken advantage of the intermediary channels, mostly for mortgages, to expand beyond their regional footprint. This has enabled these cooperatives to expand significantly in the last decade. Similarly, clever use of technology and marketing could allow some to broaden their geographic reach in the digital era while still being grounded in their local communities, which we believe will remain their key competitive edge. Customer franchises outside their core region are likely to be more sensitive to competition, as highlighted by some unsuccessful attempts at geographical expansion, for example, France's Credit Agricole in Greece.

Strong deviations in cooperatives' creditworthiness

As well as differing significantly by size, cooperatives exhibit divergent business models, performance, capital, risk, and funding profiles. This indicates that the cooperative organizational structure does not in itself reinforce or undermine a bank's business model or creditworthiness. While there are some exceptions, these characteristics generally accompany the cooperative or mutual status:

• A historically strong franchise and high share of sticky customer deposits, reflecting regional roots and customer proximity; and
• Weaknesses springing from more complex organizational structures and cost redundancies, as most groups comprise separate legal entities that enjoy operational independence.

Table 2

When assessing the creditworthiness of European cooperative and mutual groups comprising separate legal entities, we generally consider these groups as a single risk unit, regardless of the level of centralization. This is because mutual support mechanisms or cross-guaranty schemes exist between member banks of the same network, by which each member is bound to support sister banks' liquidity and solvency. In most cases with mutual support, we rate each member bank the same, reflecting the creditworthiness of the overall group. However, not all mutual support systems are structured with unlimited and unconditional guarantees. Among the rated groups highlighted in this report, those without such guarantees are, for example, the few mutual support networks, organized according to the European legislation as institutional protection schemes (IPSs): Cooperative Banking Sector Germany and Raiffeisen Banking Group Austria. Given these limitations, we also examine a number of factors that could result in some member banks being rated differently, particularly if they operate lines of business that are not essential to the cooperative groups' core activities. Group structure and relations remain key rating factors for our ratings on cooperative group members.

Local identity provides a key competitive edge, but no longer guarantees success

The social factors differentiating cooperatives from commercial banks remain, reflecting the ownership structure and social values at the core of the business model:

• They work in the interests of their members not external shareholders; and
• They mostly have a strong regional focus and proximity to communities.

Cooperative groups have a much broader network of branches than their commercial peers, including in non-profitable and rural areas. This demonstrates how they prioritize customer proximity over maximizing profits. While under pressure to improve efficiency, cooperatives have been cutting branches and merging small group members, although to a lesser extent than commercial banks. This also allows cooperatives to increase their role outside the cities as commercial peers retreat from these areas. Some entities, such as Finland's OP Financial Group, also have bonus or loyalty programs tying the customers to the group.

At the same time, increased regulatory and market requirements regarding environmental, social, and governance, as well as increased financial conduct regulation, resulted in a material catch-up by commercial banks, closing the gap regarding the social aspects of banking. Cooperatives' product offering is generally no longer a differentiating factor as the availability of banking services, low interest rates, and high transparency of pricing for banking products have long since aligned affordable pricing and commoditizing of banking offers. All these developments render customer loyalty more sensitive to disruption. While strong social reputation--gained over decades of superior competitive position--will last in the medium term, finally, cooperatives are exposed to the same competition as any commercial peer (For more details see our series "Tech Disruption In Retail Banking" and "The Future Of Banking"). In this context, it will be crucial for cooperative groups to offer customers the same service comfort and digital standards as commercial banks, while making their social commitment to local communities transparent and highlighting their differentiated proposition, which adds value to customers and society.

Centralization can improve brand management, client experience, efficiency, and risk management

In 2008-2011, a number of European cooperatives, most prominently in Ireland and the U.K., failed, highlighting that single cooperatives are not immune to the irrational exuberance seen elsewhere in the industry and the associated profitability pressure--particularly if coupled with low sophistication of risk and governance standards. Lessons learned led to a wave of consolidation and centralization of cooperatives, which is ongoing. While cooperatives keep their de-centralized organizational set-up, most groups have been centralizing risk management, product offerings, and many other aspects of banking. Centralization trends have been propelled by the search for measures to protect the customer franchises and improve efficiency and risk management to ensure sustainability.

Rabobank in the Netherlands and Finland's OP Financial Group were among the first cooperative groups to move decisively toward centralization, becoming a blue print for many other cooperative groups in restructuring, such as, for example, Italy's Gruppo Bancario Cooperativo Iccrea and Savings Cooperatives Group Hungary. While single cooperative banks remain independent legal entities, there is high level of centralization of management.

French cooperatives BPCE S.A., Groupe Credit Agricole, and Credit Mutuel Group also enhanced operational efficiencies, centralization, and the control mechanisms, which supported these groups' development. French groups are distinctive as despite the inverted ownership structure--in which the central body is owned by affiliates--the central body is in charge of the network's governance and has the supervisory power to control its affiliates. The local and regional banks of a group with a central body have significant autonomy in their lending decisions, for example, but the group's policy and strategy are set centrally. Given French groups' status as G-SIBs, their transformation was partially driven by the regulatory pressure to improve governance standards and changed regulatory requirements on group resolvability. For example, in 2016, the Crédit Agricole group's ownership structure was changed to eliminate cross shareholdings, whereby the regional banks owned 56.7% of the central body's shares and the central body owned around 25% of the shares in the regional banks.

The above-mentioned groups are more centralized and integrated than European cooperative groups organized as IPS'. For example, in Germany and Austria, the two largest IPS cooperative groups have an inverted and complex ownership structure and organization, meaning their central bodies have much more limited control over the affiliates. At the same time, while we do reflect these nuances in our analyses, we see German and Austrian groups as sufficiently cohesive to regard them as one single risk unit. We also acknowledge joint risk and governance steering in these groups, as well as efforts to leverage scale and improve efficiency. Also, a strong consolidation momentum has reduced these groups' complexity: over the past 10 years, the number of cooperative institutions in Cooperative Banking Sector Germany reduced by 27% to 841 from 1156, and at Raiffeisen Banking Sector Austria by 30% to 380 from 539. In 2016 and 2018, Cooperative Banking Sector Germany also achieved a major step in simplifying its organizational structure by merging its two central banks and separately its two real estate specialists. Raiffeisen Banking Sector Austria remains the cooperative group with most organizational complexity--with eight regional Raiffeisen Landesbanks sitting between the local cooperatives and the central bank--a unique legacy structure in Europe.

Groups with strong franchises may have more time to prepare for disruption

Cooperatives come into the era of secular change from very different positions. At one end, groups like Credit Agricole provide cradle-to-grave provision of financial services for clients, and enjoy their own primary customer banking relationships. This franchise and single-stop access may help to protect their position as long as they can meet customers' basic digital needs. For cooperative groups with strong customer franchises, we consider the risk of a major disruption and quickly loss of ground against tech players is generally less than for their respective non-cooperative peers.

On the other hand, some cooperatives lack a particular competitive edge as they offer simple, highly commoditized products, meaning the customer franchise has become fragile. More generally, most cooperatives are increasingly targeting "noncore" customers, including via broker and online channels, where the commoditized nature of customers and products means weaker ties to customers.

The COVID-19 pandemic has also triggered a quick shift to serving customers through online or mobile applications in many areas of the business world, and is likely to accelerate digital transition. We believe it will also hasten the trend away from branch banking, likely leading to more branch closures. This development might weaken long-lived customer ties and expose cooperatives more severely to competitors, requiring a stronger push to improve customer experience.

For most cooperatives, we see the digital transition and level of customer services to be broadly in line with market standards, indicating that a de-centralized organizational structure do not impair the mindset for digital transformation. The absence of performance pressure from the owners could even help cooperatives transform as they don't have to worry as much that digital investments will depress their earnings.

However, groups with modest performance and low efficiency could have limited capacity to invest in transformation in line with peers. Furthermore, cooperatives that don't adjust sufficiently quickly may eventually lose customer loyalty. Such risks also exist for highly de-centralized groups. Even if they have the scale and capacity to invest and transform, consensus-based and slow decision- making processes may eventually impair competiveness, as the pace of internal processes and consensus readiness may not suffice given the increasing pace and extent of change needed.

Inefficiency is the payoff for de-centralized structures and customer proximity

Decentralized structures with extensive branch networks result in customer proximity, knowledge of the market, and symbiotic ties between banks and customers. However, they also lead to overlaps, redundancies in processes and functions, and overall lower efficiency than commercial peers. To a large extent, this is a conscious decision reflecting different priorities to commercial banks, namely customer proximity over profit maximization.

While it is generally more difficult for cooperatives to balance their values against benefits of the centralization and efforts to improve efficiency, some successful groups demonstrate that it is not impossible (see chart 1). Cooperatives can seek economies of scale by pooling certain functions with other cooperative banks--such as back-office tasks and data processing--and creating joint platforms in fields where size matters, such as asset management or specialized financial services. With the groups that have embraced these synergies most readily, their local cooperative banks can concentrate on their role of sales networks. The optimization challenge generally requires central bodies to reinforce their control over banks within their group, which represses member autonomy. This is a price not all cooperative groups have been ready to pay to the same extent.

Chart 1

Long-term focus on stability often results in relatively high capitalization

Lack of pressure for investor returns helps cooperatives to accumulate capital. We more often see capital as a strength to the creditworthiness for cooperatives than for their commercial peers. This is the case for all rated cooperatives in Europe, with four exceptions. The chart below shows S&P Global Ratings' risk adjusted capital (RAC) ratio ranking for rated cooperatives. RAC before diversification is our main measure for a bank's capitalization.

Chart 2

To diversify their funding and capital structures, most cooperatives have also found a way to access the capital markets without compromising their cooperative status. This is mainly by acquiring listed subsidiaries or, for example, in the U.K., by creating new Common Equity Tier 1 (CET1) instruments called Core Capital Deferred Shares. OP Financial Group is an outlier among the European cooperatives, as it did the opposite and delisted OP Corporate Bank PLC, which acts as treasury for the group. This was to preserve a pure cooperative ownership structure and avoid pressure on profit distribution to external shareholders.

While conditional in theory, we expect IPS cooperative support schemes to remain a reliable source of help for its members in distress

For IPS-organized cooperatives, the amount of capital available under the support schemes is generally accounted for as reserve and not equity, and is not reflected in the capital ratios. In our rating methodology, we generally follow the regulatory approach and exclude such reserves from the capital ratios. This is mainly because the support commitment remains conditional, at least in theory. While for individual cooperatives there is no option to support or not, the support scheme governing body has a power of choice, which is essential to preventing moral hazard in cooperative groups. Also, apart from the existing reserves, such schemes are generally set in a way to allow additional resources to be drawn from group members and support to be provided in a timely manner to a member in distress. We expect IPS cooperative support schemes to remain a reliable source of help for its members in distress. As such, we reflect the mutual support schemes' benefits as qualitative considerations in the rating construct.

Stability is a higher priority than short-term profitability

Focus on low-margin bread-and-butter banking products, low efficiency, and generally high capitalization result in relatively low returns on equity for most European cooperatives. This reflects the design of the cooperative banking approach. However, some aspects complicate a direct performance comparison with commercial banks:

• Cooperatives typically enjoy a lower cost of capital given their capacity to issue affordable cooperative shares. They are therefore neither driven by return on equity (ROE) metrics nor under pressure to generate returns for external investors.
• Bottom-line profitability is generally not comparable with commercials banks as, for example, cooperative banks' net revenue streams may include benefits paid to members for subsidized interest, fees, or for interest on customers' cooperative shares (an equivalent to commercial banks' dividend payouts). In essence, this makes the bottom line of cooperative groups more akin to the post-distribution profit and loss line at commercial peers.

Taking into account these limitations and the fact that cooperatives' capital base is generally higher than that of commercial peers, a comparison of unadjusted ROE or ROTE metrics is of limited value. For example, chart 4 illustrates how profitability metrics are affected once they have been "normalized" for an assumed 13.0% CET1 ratio.

Chart 3

Low profitability is also not necessarily detrimental to a cooperative group's creditworthiness. While returns do matter, we see the stability of capital generation and sufficient internal capital build up to cover for risks and growth as more important. While leading to low profitability, a simple product offering, customer proximity, and absence of pressure to generate investor returns tend to result in relatively stable profitability. This leads to greater resilience to downturns compared with commercial peers. Also, reliance on interest income has been diminishing, as many cooperatives managed to diversify their income sources away from interest income, which is supportive amid low interest rates.

Chart 4

While we value stability over the absolute level of returns, risks can emerge if profitability gets structurally too low, rendering a group more sensitive to adverse scenarios. These could include loss of customer franchise to disruptor banks, a sharp economic downturn, or challenging a bank's ability to comply with regulatory requirements or pass regulatory stress tests. Particularly small cooperatives--much like their small commercial peers--might struggle with compliance costs and need for IT investments, while under margin pressure due to focus on highly-commoditized products (mainly savings and loans/mortgages). While they can exist for some time showing marginal profitability, the pressure increases and they might need to take more radical actions, such as changing their business model (or consolidating) to ensure long-term survival.

Generally low risk profile helps limit losses in downturns, with negative outliers being helped or absorbed by the group

Long-term focus on stability, absence of shareholder expectations, and simple product offerings often result in cooperative groups having a lower risk profile than commercial peers. This is especially the case for larger and diversified cooperatives--such as those in Germany and France--whose credit quality we expect to be more resilient in downturns compared with their commercial peers.

At the same time, cooperatives are not immune to market downturns and yield pressure. Protecting profitability despite declining asset yields--in typically a narrow sphere of operations, often heavily biased towards mortgage lending--can lead to more risk taking. This was demonstrated by a number of cooperatives that failed during the previous financial crisis. Most of the cooperative banks that failed were engaged in risky activities not commensurate with their risk-taking capacity, whether related to real estate lending or treasury portfolios. Problems can relate to any combination of the following setup:

• Small cooperative entities with unsophisticated risk management and governance;
• Central institutions engaged in wholesale and more commercial banking-style business;
• Specialized lenders and banks with narrow business activities; for example, if they concentrate on mortgages and deposit-taking, and would suffer badly in a housing market correction combined with high unemployment and default rates; similarly, cooperatives highly focused on the SME sector can be harder hit in downturns than their larger commercial peers.
• Cooperative expansion in non-traditional or non-regional banking operations.

In cases of struggling cooperative group members in Europe, the stability of the wider group or mutual support mechanism helped to overcome issues, providing an impressive track record of support in the European cooperative landscape. In the bulk of the cases, where group support was not available (for stand-alone cooperatives not belonging to a group), other solutions were found to protect senior creditors from bail in. We view this solidarity and value placed on protection of the cooperative brand as essential when assessing cooperative groups' creditworthiness.

Governance is paramount, as competitive pressure heightens amid continued low interest rates and economic downturn

While this is also true for any bank, cooperatives with their already thin margins and low efficiency may reach a point where performance is no longer sufficient to carry the risks. As we expect low interest rates to persist and economic downturn to significantly pressure banks' performances, the cliff edge point for low performing cooperatives may be nearing and could prompt banks to higher risk taking.

Cooperative groups' customers, being their owners, are responsible for oversight of the governance, strategy, and risk management processes. The question is: are customers in a position and willing to execute these roles to ensure proper governance and control to prevent undue risk taking? While cooperative groups' customers are neither sufficiently sophisticated nor willing to oversee the cooperative groups, we see no material difference to non-cooperative peers; individual shareholders in commercial banks tend to exhibit similar skills and behavior. We see the topic as more nuanced for cooperatives that have no institutional shareholders, which most commercial banks have. Generally, however, while governance issues may arise, cooperatives are not more prone to them than other banks. As for all banking peers, we see oversight by the regulator and market discipline as key.

While some of the failed cooperatives had weak boards, with politically- or locally-connected appointees that have limited discernable relevant expertise in banking, regulators have raised the bar in the past years, mitigating the risks. Lessons learned resulted in all cooperative groups' imposing a central control and steering body to supervise all group members. Noteworthy differences do exist, but we would not mark lack of control and oversight as a particular weakness for any rated European cooperative group. At the same time, limitations to some group's joint governance, risk management, or financial disclosure could prevent a stronger rating assessment. While history does not show a particular track record of abuse of power by management, the general risk of governance problems arising from low financial transparency is not negligible and will gain weight amid profitability pressures.

Resolvability: feasible for most, barriers remain

As for all banks, we view the path to resolvability as a long journey. Today, we are sufficiently comfortable with progress on resolution to apply rating uplift to four European cooperative banking groups in recognition of their additional loss-absorbing capacity (ALAC) buffers. These are Finland's OP Financial Group, France's BPCE and Groupe Crédit Agricole, and U.K.-based Nationwide Building Society. We also apply this approach because we expect banks will in time address other material barriers to resolvability. Their overall resolvability could impair their eligibility for ALAC rating uplift if we identify structural or persistent barriers to an effective resolution.

Resolvability issues have sparked the transformation of many cooperatives in recent years, as they have been simplifying their group structures. Still, concerns about resolvability remain higher for cooperatives than commercial peers, reflecting generally more complex legal and organizational structures and greater operational and legal barriers for an effective resolution. One further aspect that may impede cooperatives' effective resolution: in the case of cooperative banks, ALAC-eligible instruments--as their whole equity base--are generally primarily owned by retail investors. Some regulators see possible financial stability consequences from a future bail-in of instruments owned by retail investors. While we currently believe that cooperatives' equity base and non-equity ALAC held by retail investors is not an impediment to an effective resolution, we would monitor the developments and might revise our view if we saw continued bailouts or general unwillingness to bail in retail investors.

Joint resolution is not the path for all

While most cooperatives groups act as one unit in a resolution scenario, we understand that some groups would fall apart after reaching the point of non-viability. For example, for the German and the Austrian cooperative sectors joint group resolution remains remote, reflecting high de-centralization and peculiarities of the IPS mechanism. The groups include both significant institutions (SIs) and less significant institutions (LSIs), with different authorities responsible for the direct supervision of the individual IPS members. Under the Single Supervisory Mechanism, the European Central Bank (ECB) directly supervises all SIs through Joint Supervisory Teams, while the supervision of LSIs is conducted by national supervisors. We understand that there is an ongoing regulatory discussion over the effectiveness of some groups' mutual support schemes in a resolution scenario. While other European cooperative groups enter resolution together, IPS groups' members would then go separate ways if the mutual support schemes have already failed to solve problems.

What could change our view on Europe's cooperative groups?

Some cooperative bank ratings are currently on a negative outlook, mainly reflecting massive challenges that we expect the banking industry to face over the medium term because of the effects of the COVID-19 outbreak. We acknowledge that the main risks to our ratings on cooperatives are no different from the drivers for peer commercial banks, which face similar challenges. These include:

A harsher macroeconomic environment.   Cooperative groups' asset quality will deteriorate, with higher provisions adding to earnings pressure and profitability challenges. A softer, longer recovery would test resilience and may weigh on our ratings on cooperatives. Rating actions on individual groups could occur where we expect a group's metrics to move durably outside our parameters for the rating. This could include higher-than-anticipated credit losses impairing capitalization or implying a less risk-averse stance than we assume in our ratings today. COVID-19-related effects could also challenge some groups' solidarity mechanisms; we will monitor any evolving trends and might downgrade such cooperative banks, if we expected group support to be less likely.

Digital Disruption.   We think this might substantially change the competitive landscape and we need to carefully examine how cooperatives can adapt to the digital era. The mantra of 'stability over short-term profits' may no longer suffice if customer preferences/demands change and the banks cannot match them. At the same time, cooperatives' reputation and perceived long-term focus, security, and customer proximity--the competitive edge for many--might also represent an opportunity to positively differentiate against competitors.

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