What happens to banks when the economy is uncooperative

It’s very easy to dismiss the Moody’s downgrade of the Co-operative Bank today – after all, who pays attention to ratings agencies these days?

That is, until you look at the details of the downgrade notice. Moody’s has dropped the rating on the Co-op’s debt not by one notch, as it did when it stripped Britain of its AAA status, but by a whopping six notches, all the way from A3 to Ba3, in the case of senior debt. Tempting as it is to dismiss everything the agencies say as junk, it’s hard to ignore a downgrade of that scale: it suggests that the agency now thinks there’s a statistically significant chance that the bank will default.

It’s deeply awkward for the Chancellor – in part because he championed the bank’s now-defunct plan to buy up 632 Lloyds branches, in part because Moody’s says it thinks Co-op may need Government support in order to survive. That would cross over a red line George Osborne has set every time there is a question of whether banks might need more support: the Treasury has no intention of pumping yet more money into failing banks.

And indeed when I asked the Chancellor that question this morning – about whether he would countenance a government-funded capital injection into Co-op – he sidestepped the issue entirely. However, unlike most other banks, the mutual structure of the Co-op means it doesn’t have the option of raising shares. It must rely either on a cash injection from its parent company – the one that owns the retail stores – or must divest certain key units in order to make its balance sheet look less precarious.

In a sense it’s just another aftershock following on from Britain’s own home-grown economic crisis. Co-op’s balance sheet is particularly polluted with bad debts associated largely with the commercial property assets it picked up when it bought Britannia Building Society at the height of the crisis. The scale of the commercial property crash (there really was a crash there) means many of the loans to the sector are underwater, and given the Bank of England believes British banks are forebearing on many loans to the sector, that means there are likely to be more losses further down the road.

It’s scary stuff – particularly given the memory of what happened in the British banking system back in 2007 and 2008. But on the other hand, consumers shouldn’t panic. Unlike back then there is a decent, well-defined system of deposit insurance which will protect deposits up to £85,000 (back in 2007 the fully-insured limit was a terrifying £2,000). Moreover, new rules on bailing in depositors mean that theoretically they will no longer be near the back of the queue if there’s a collapse.

However, we are still not at that point yet. Even if it is indeed true that the bank needs external support, and the Government isn’t willing to provide it, the Co-op group has money it could put towards supporting the bank. However, with George Osborne spending today and tomorrow with finance ministers and central bankers – not to mention the International Monetary Fund, which is in the middle of its annual survey of the UK economy – the timing is awkward. A reminder, if any were needed, that Britain’s economy and its financial plumbing are in far from pristine condition.