Adding value to the case for building societies

Building societies are mutual organisations.  This means that they have no shareholders and operate solely in the interests of their members. A member is a person who has a savings account or a mortgage loan. Each member has voting rights to influence how the building society is run.

The earliest building societies were established during the Industrial Revolution by skilled workers who wanted to save money together to build their own homes. The first known building society was formed in 1775 in Birmingham. Like all of the early societies, it was a terminating society and it closed after all the members had funded and built their homes.
The building society movement expanded as societies started to accept savings from members who did not want to build a house. This led to the formation of permanent building societies.

For many years, building societies dominated the mortgage market. A mortgage loan is a loan secured on a property. Most mortgage loans are used to buy a house. However, in the 1980s deregulation of the mortgage market took place. This removed government rules, regulations and laws from many aspects of financial services, and encouraged institutions such as banks to enter the mortgage market alongside the building societies.

At the same time, the 1986 Building Societies Act allowed building societies to offer a wider range of financial services than previously. It also allowed the mutual societies to demutualise (convert into banks). In 1989 Abbey National was the first building society to demutualise and become a public limited company (plc). The next development was in 1995, when the Cheltenham and Gloucester became a subsidiary of Lloyds Bank. Since then seven societies have demutualised. As some building societies converted, others began to promote mutuality.

This case study explores the two different organisational forms, mutual and plc, which now operate in the same financial market.

The role of building societies

The primary business of a building society is to:

• attract savings from its investing members
• make loans for house purchases to its borrowing members.

The savings of the investing members provide most of the funds that the borrowing members use to buy their properties. The borrowers pay interest on their loans and this is used to pay investors interest on their deposits. About 23% of all outstanding residential mortgages in the UK come from building societies, but they currently account for nearly a third of new mortgage business.  They also hold about 18% of all personal deposits and again, account for about a third of all new business in this area.

A number of societies offer related products such as offshore accounts, cheque accounts, credit cards and stockbroking services (the purchase and sale of fixed interest securities and of shares). Some provide estate agency services and many also sell a range of insurance products. Building societies operate under their own specific legislation: the Building Societies Act 1986, which was amended by the Building Societies Act 1997. This act relaxed the regulations governing the societies.

Key Data at the end of 1999
BUILDING SOCIETIES:
Assets £160 billion
Branches 2,400
Staff 40,000
Investors 17 million
Borrowers 3 million
Note: All statistics include Bradford & Bingley Building Society, which announced in April 1999 its intention to put a formal demutualisation recommendation to its members in summer 2000.

The Building Societies Commission, which is appointed by HM Treasury and reports annually to Parliament, regulates the societies. Building societies that sell products such as life insurance are also regulated under the Financial Services Act and governed by the self-regulating bodies established under the Act. The Building Societies Commission will disappear and become part of the Financial Services Authority (FSA) which will regulate building societies under the proposals contained in the Financial Services and Markets Bill, currently making its way through Parliament. Building societies also support the industry-wide codes of practice that cover banking and mortgages.

The organisational structure of building societies

Both mutuality and plc status have their advantages and disadvantages, strengths and weaknesses. This is why these different types of organisation can exist side by side in direct competition with each other.

Businesses exist to organise economic activity and add value in the economic system. They control resources and turn these resources into products that customers want. Financial service providers differ from other businesses in that their customers both provide the capital and purchase the financial services of the organisation.

A mutual’s customers are, in a sense, its ‘owners’; in plcs the customers and owners are usually different.  The range of stakeholders in both mutuals and plcs is largely similar: employees, customers and suppliers. However the plc has an additional stakeholder, the shareholder who supplies capital to the organisation.

Mutuals versus plcs

Because of the way in which they are organised, mutuals do not need to pay dividends (a share in the profits of the company) to shareholders. This means that building societies can charge less to borrowers and pay more to savers. The net margin (the difference between the interest rate the customer receives for their savings and the interest rate they pay on their mortgage), therefore, is narrowed.

Margin comparison for converted institutions and building societies (1999)
PLCs %
Abbey National Bank 2.45
Halifax Bank 2.25
Woolwich Bank 2.10
Alliance and Leicester Bank 1.61

BUILDING SOCIETIES %
Nationwide BS (yr to April 1999) 1.72
Coventry BS 1.14
Britannia BS 1.07
Yorkshire BS 1.03
Source: Individual accounts or press statements

The net margin suggests that building societies need fewer resources to operate and make a profit. As previously mentioned, financial institutions get their resources from their customers, so the extra money needed by banks to pay dividends is taken from them.

This margin advantage is supported by an independent survey from Moneyfacts in December 1999 of the 30 largest mortgage lenders. They show that the cheapest loans, when calculated over a ten year period, were offered by building societies. In the survey, building societies held 15 of the top 20 places.

Customer benefits are also found in savings. Another Moneyfacts study published in December 1999 looked at the performance of TESSAs over the previous five years. This found that eight of the best ten performing accounts to the beginning of 1999 were from building societies.

An argument against the mutuals is that there are no owners to discipline the company and ensure its efficiency. Shareholders will only invest in organisations that make a profit or operate efficiently, so their goodwill is dependent on organisations performing to the best of their ability. However, in practice, plc organisations may lack discipline too, as they may try to create short term results to satisfy shareholders rather than adopt long term strategies.

It is arguable that competition and the low exit costs for members create discipline for the mutuals. If members are dissatisfied, they can withdraw their savings and transfer their loans, thus reducing the resources that the mutual has to operate with.

Financial inclusion

Research sponsored by the Joseph Rowntree Foundation has shown that approximately 7% of all households in the United Kingdom have no account with a financial institution; 84% of these are tenants of social housing landlords such as local councils or housing associations.

Building societies, which were originally set up to help people who might otherwise be excluded from the financial organisations, continue to address this problem. For example, they offer straightforward passbook savings accounts which show customers exactly where they stand. They also operate instant access accounts with a free cheque cashing service.

Another advantage of not having to pay dividends to shareholders is that mutuals have been able to keep branches open in areas which other institutions have abandoned because they found them unprofitable.

The Centre for Urban and Regional Development, at the University of Newcastle upon Tyne, studied patterns of branch closures and openings between 1995 and 1998. Its authors concluded: ‘There is evidence that building societies are less likely to close branches in socially deprived areas as well as evidence that building societies are opening in the same areas that converters are closing branches.’ [From the report: The Contribution of British Building Societies to Financial Inclusion]

The authors suggest a number of reasons for this:

• Building societies were established with the original intention of providing the opportunity to purchase homes to those whose needs were not being met elsewhere.
• Their organisational structure gives them the flexibility to provide a service to members rather than simply to maximise profits.
• The local identity of many societies, as illustrated by their names, may make them less likely to withdraw from communities they have historically served.

Benefits of mutuals

There are numerous benefits that arise from the existence of mutuals in the financial services market:

• Having different types of business organisation makes the market more responsive to external and internal change.
• Building societies provide competition for banks within the financial services market (for example, through offering lower rates of interest).
• Building societies provide greater choice to the consumer.

It is the existence of these and other external factors, which makes mutuals a classic case for public policy intervention. At the same time, there are a number of arguments for the conversion of mutuals into plcs:

• Diversification: it was thought that the mortgage market would grow more slowly and competition is therefore more likely to increase.
• Capital raising: as plcs, converted societies gain access to more capital markets.
• Acquisitions: these are easier for plcs who can offer their own shares, whereas building societies have to use cash to buy companies.
• Increased accountability: plcs can be considered more accountable to their shareholders than building societies are to their customers.
• Large mutuals are remote from their members.

New legislation, such as the Building Societies Act 1997, made some of these reasons obsolete and others are open to dispute. For example, many people would argue that member pressure makes mutuals accountable and that mutuals are actually less remote from their customers because the link between supplier and consumers is more direct.

Conclusion

There appears to be no single structure that is ideal for a financial services organisation. It cannot be assumed that the most successful will be either the largest or the most diversified.

Some of the strategies which lay behind conversion have also been called into question by the potential for new organisational structures within the financial system. Internet banking is a good example. Technology is revolutionising bank processes so financial institutions do not necessarily have to operate through hundreds of branches.

However, building societies continue to come under a combination of pressures including:

• increased competition from non-traditional suppliers, for example, internet banks or supermarkets
• the challenge of the carpetbagger (individuals who see a way to make money by opening accounts in mutuals so that they will receive windfall payments if the mutuals convert into plcs).

Building societies are continuing to evolve to meet these new pressures. To deter carpetbaggers, some of them have raised the minimum balance requirements or demanded that new members live in a particular geographical area (or even occasionally stopped opening share accounts for new customers).  Most large societies have now introduced charitable assignment clauses in their account opening documents so that, if the society converts to a bank, any windfall payment automatically goes to charity.