Revenge of the building society

Now, building societies are back with a vengeance. A renewed focus on cost control and lending quality, together with highly rated customer service, have helped profits. With banks viewed as little better than criminals with call centres, many building societies stand better. Local services and a community connection have helped many, including mutuals such as the Co-operative.

"I think it fair to say that building societies have had a 'good' credit crunch and are largely untouched by payment protection insurance (PPI) and other consumer storms. Their management is relatively modestly paid and their culture is not one of profit maximisation," said Simon Walker of consultancy KPMG, which contributed to a recent report on the sector. Indeed, it is clear from credit reports that building societies are not often making enough money to expand aggressively. That will come, Walker argues, when banks' free current accounts, which were cross-subsidised by other products, finally start to disappear.

Qualitatively, building societies are doing better. They occupy many of the top places in best-buy tables for both mortgages and savings, quite out of proportion to the relatively small size of their lending and savings base. But, while the services are well regarded, how about their financial strength?

"Building societies have generally emerged from the difficulties of the financial crisis in better health than the UK banking industry as a whole," said Standard & Poor's analyst Dhruv Roy. Rival credit agency Fitch last month reaffirmed ratings at five medium-sized societies, and only lowered the rating on one, Skipton Building Society.

"The so-called back-to-basics approach to banking has served building societies well through the financial crisis and they have generally come through it well," said Adrian Coles, director-general of the Building Societies Association. The sector's total assets rose by 3 per cent to £315bn this year, according to KPMG.

"As the business models of larger banks evolve in response to regulatory and market developments since the financial crisis, building societies could claim, with some justification, that they are already further along the road to maintaining sustainable franchises in the new financial landscape," Mr Roy said in a research report.

Results in May from the largest building society, Nationwide, showed underlying annual profits rose 10 per cent, with bad debts stable and cost ratios slightly down. It has always been about more than profits. Building societies often exude a rather fashionable localism, which not only makes for friendlier face-to-face customer service, but better informed lending decisions. Ombudsman data shows building societies account for only 2 per cent of complaints, while banks account for 65 per cent.

Although the number of building societies has fallen from 100 to 47 since World War II, the business model is little changed. The conservatism embodied in limits to commercial lending (a maximum quarter of advances) and sourcing from deposits (a minimum of a 50 per cent of funds) have protected them from the worst excesses of the banking crisis.

That said, building societies still have a long way to go in transparency and democracy. They produce far less financial information than banks and few members bother to vote. In the absence of critical oversight, directors are often as overpaid for the size of assets they oversee as are those in banks.

Building societies may not have to pay dividends to shareholders, but neither do they have shareholders' funds to call on in times of crisis. So while the top seven building societies have an average Tier One capital ratio of 12 per cent, somewhat higher than most banks, that capital cushion is money left fallow for contingencies that societies have rarely encountered.

The future for Pibs

Permanent interest-bearing shares (Pibs), a subordinated bond peculiar to mutuals and often issued by building societies, have been a rollercoaster ride in the financial crisis. This stunned the conservative private investors who sought their steady income, although they were never quite as safe as originally thought. "They can be attractive, if you know what you are doing," said Jason Hollands of wealth manager Bestinvest.

Investors can earn yields of 7-10 per cent. This is well above the returns available from government bonds or investment-grade corporate bonds, but there are considerable complexities.

The first is the effect of Basel III. Pibs are being phased out of Tier One capital, so gradually building societies will have to issue new types of deferred share, which are better for absorbing losses. Quite what shape these will take is still uncertain. It will certainly be tempting for societies to either repay existing Pibs, where they are expensive as standalone capital, or to offer to switch holders into an explicitly loss-absorbing class. Either way, this is likely to lead to further gains for existing Pib holders, but may mean a gradual end of this attractive class of income-generating share.

Already there are hints of such activity. Yorkshire Building Society recently tendered for its 5.649 per cent Pibs at prices below par but 10 points or so above the prevailing price and received acceptances of over 90 per cent. Other societies are bound to follow, analysts say. The move has cemented gains of almost 10 per cent across the sector. "If they aren't much use as Tier One capital we could see a lot of tenders,” said Mark Taber, a professional investor who runs a website for private fixed-income investors.

The second complexity is the status of 'calls'. These are issuers' options to repay an issue early. Until 2011 issuers had always repaid issues at the first call date, and then issued a fresh security. However, that changed last year when Principality Building Society didn't issue a call, but reset its 5.375 per cent Pib to just 1.05 points over the London Interbank Offered Rate (Libor - the interest rate used by financial institutions for loans between each other). This has chopped the running yield from around 8 per cent to just 1.81 per cent, where it now trades as a floating rate note.

Clearly, the fall in Libor and gilt yields in the past three years has made the reset rates written into some prospectuses incredibly tempting as a very cheap source of funding (and thus bad for the Pib holder).

For new Pib investors, there are two ways round this. One is to pick issues with call dates a few years into the future, by which time interest rates, and thus the five-year gilt yield or Libor benchmarks, may have risen. The second is to pick a more generous reset rate, so that a call doesn't hit income too hard.

Some attractive Pibs

The strategy for choosing Pibs is to maximise yield without compromising safety or the durability of that income. With the issue of call dates now salient, the safest strategy is to pick issues which are either perpetual or have at least four years to run before call – enough time for floating reset rates to revert to more normal levels.