Failings in management and governance Report of the independent review into the events leading to the Co-operative Bank's capital shortfall Sir Christopher Kelly 30 April 2014 Failings in management and governance Report of the independent review into the events leading to the Co-operative Bank's capital shortfall Sir Christopher Kelly 30 April 2014 TERMS OF REFERENCE To investigate the robustness and timeliness of the Board's and the management's strategic decisions which ultimately led to the need to adopt a Capital Action Plan by the Co-operative Bank to address its £1.5 billion capital shortfall; To look at the management structure and culture in which those decisions were taken; lines of accountability which governed those decisions; and the processes which led to them; To identify lessons which can be learnt to strengthen the Co-operative Bank and the wider Co-operative Group, and the co-operative business model generally; To review the financial accounting practices of the Bank, the representations made by management to the independent auditors regarding these practices and the role of the independent auditors in reporting to the Audit Committee of the Bank and giving an opinion on its financial statements; To publish the findings of its review to members, colleagues and other key stakeholders. LEGAL DISCLAIMER The Report has been prepared by Sir Christopher Kelly as independent reviewer commissioned by the executive teams, together with the Boards, of the Co-operative Group Limited (the Group) and the Co- operative Bank plc (the Bank). It is published at their request. The Review's Terms of Reference are set out above. The Report is not for the purpose of guiding or influencing the conduct or decisions of any person other than the Group and the Bank. Accordingly, it must not be relied upon for that purpose by any party. Sir Christopher accepts no legal responsibility or liability for the contents of, or any omissions from, the Report or any actions taken or decisions made by any party as a consequence of the views, findings and lessons set forth in the Report. The full terms of the disclaimer in respect of this Report are set out at Appendix G. Contents 1 INTRODUCTION TO THE REPORT ................................................................................................................ 1 2 EXECUTIVE SUMMARY ................................................................................................................................ 4 3 BRITANNIA MERGER ................................................................................................................................. 12 4 MANAGEMENT OF THE LOAN BOOK ........................................................................................................ 31 5 PAYMENT PROTECTION INSURANCE (PPI) ................................................................................................ 39 6 RISK GOVERNANCE AND CONTROL FRAMEWORK ................................................................................... 41 7 IT REPLATFORMING .................................................................................................................................. 54 8 PROJECT UNITY ......................................................................................................................................... 68 9 VERDE ....................................................................................................................................................... 75 10 INTERACTIONS WITH THE REGULATOR .................................................................................................... 82 11 ACCOUNTING JUDGEMENTS..................................................................................................................... 86 12 CAPITAL ..................................................................................................................................................... 98 13 GROUP AND BANK GOVERNANCE .......................................................................................................... 112 14 LESSONS .................................................................................................................................................. 123 APPENDICES .................................................................................................................................................... 131 APPENDIX A – ABOUT THE REVIEW ........................................................................................................ 132 APPENDIX B – ADDITIONAL FINANCIAL INFORMATION ......................................................................... 134 APPENDIX C – HISTORY OF THE CO-OPERATIVE GROUP ........................................................................ 137 APPENDIX D – RELEVANT INDIVIDUALS .................................................................................................. 142 APPENDIX E – GOVERNANCE AT OTHER RETAILER-OWNED BANKS ....................................................... 144 APPENDIX F – GLOSSARY ........................................................................................................................ 146 APPENDIX G – LEGAL DISCLAIMER .......................................................................................................... 151 1 INTRODUCTION TO THE REPORT 1.1 This report is the result of an independent review of the events which led to the capital shortfall announced by the Co-operative Bank in June 2013. It was commissioned jointly by the Co- operative Bank (the Bank) and the Co-operative Group (the Group). It describes what happened, identifies the root causes and draws the lessons. Except where I state otherwise, the period covered by this Review runs from the first quarter of 2007 to the announcement of the shortfall. My terms of reference are in the front of the Report. 1.2 I began my work at the end of August 2013. As far as I am aware, I was given full access to all relevant internal papers, where these could be identified. In addition, the Review team conducted over 130 interviews with current and former employees, with external Bank advisers and with others. I also had the advantage of seeing written evidence volunteered by a number of individuals and organisations in response to an invitation published in Co-operative News and circulated to staff in the Co-operative Banking Group and the Co-operative Group. I am grateful to all those who agreed to be interviewed or who provided information in other ways. To encourage them to be as open as possible, interviewees were told that I would not attribute any views to them by name in my report without their agreement. I understand, however, that the regulatory authorities have the power to request any information from me relevant to investigations they may be pursuing. 1.3 The only member, or former member, of the senior leadership teams of the Group or Bank who declined an invitation to meet me was the Reverend Paul Flowers, the former Chair of the Co- operative Banking Group. 1.4 In order to fulfil my commission I have thought it important to spell out in some detail exactly what happened in the period leading up to the announcement of the capital shortfall. This report therefore looks at the decision to merge the Co-operative Bank with the Britannia Building Society in 2009, the abortive attempt to replace the Banking Group’s IT platform, the proposed acquisition of the Verde assets from Lloyds Banking Group and the attempt to bring the Bank closer to the Group under Project Unity. It also includes chapters dealing specifically with the Bank’s management of its loan book, payment protection insurance, governance of the Bank and the Group, risk management, capital and accounting judgements. The final chapter identifies the lessons to be learnt. 1.5 I have been impressed during this review by the commitment and attachment shown by so many to the values and principles of the co-operative movement. That commitment makes more painful the failings in the Bank described in this report. 1.6 In the pages which follow I make a number of strong criticisms of the Bank’s management and governance, and of its business practices over the last few years. My comments on governance should not be interpreted as a criticism of the co-operative model or of co-operative principles and values, for which I have a great deal of respect. It is the particular method of governance adopted by the Co-operative Group and Bank which in my view has manifestly failed, not the co- operative ideal in general. The current governance structure in the Co-operative Group, which dates only from 2001, is not the only way of putting co-operative principles into practice. 1 Other reviews 1.7 A number of other reviews have been conducted or announced since I began my work. In particular, the Treasury Select Committee has been conducting an inquiry which has yet to report into the divestment of the 632 branches of Lloyds Banking Group known as 'Project Verde', including the Co-operative Group's failed bid for these assets. The Prudential Regulatory Authority (PRA), the Financial Conduct Authority (FCA) and the Chancellor of the Exchequer have each announced formal inquiries into events at the Bank. The Financial Reporting Council (FRC) is investigating the preparation, approval and audit of the Bank’s financial statements up to the end of 2012; and the Co-operative Group has commissioned Lord Myners to lead a review of the Group's governance structures. The Bank has also undertaken