David Prosser: Building societies in the firing line

Outlook The building society movement, by and large, has had a good credit crunch. While many of the poster boys of the financial crisis have been former mutuals that chose to convert to banking status during the Nineties – Halifax, Northern Rock and Bradford & Bingley – the larger societies have escaped relatively unscathed. Just one small society, the Dunfermline, was the subject of State intervention, and others, notably Nationwide, the sector leader, have seen their reputations enhanced.

Not that the mutuals are immune from miscalculation. One reason why Chelsea Building Society, now in advanced merger talks with Yorkshire, has been seeking a partner is its troubled recent history. A £44m exposure to the Icelandic banking collapse was followed by £41m of losses on buy-to-let mortgage fraud. Other smaller societies have sought rescue deals with larger players, while West Bromwich had to raise money in order to prevent a collapse.

Still, the Financial Services Authority, the chief City regulator, is happy to concede that building societies have stood up well to the tests of the financial crisis, because they avoided the speculative. Why then, does it insist on regulatory reform that makes the sort of deal now mooted between Chelsea and Yorkshire inevitable?

Three weeks ago, Graham Beale, the Nationwide chief executive who currently serves as chairman of the Building Societies Association, warned the FSA's reforms, which make no distinction between banks and building societies, were anti-mutual and presented a serious threat to the sector.

It is difficult to disagree with Mr Beale. The FSA's new requirements on funding apply to mutuals as well as banking groups, yet building societies, with no shareholders to tap up, do not have the same recourse to funding as their quoted rivals. This problem also means they are hit disproportionately hard by the increased cost of mandatory membership of the Financial Services Compensation Scheme.

Higher funding costs would be a challenge for the mutual sector at the best of times, but the current low level of interest rates presents an additional headache. In order to compete for savers' cash, societies have had to put up with ever smaller margins and offer increasingly uncompetitive mortgage rates. To add insult to injury, they're losing market share to institutions such as Northern Rock and Royal Bank of Scotland, where government support has boosted competitive advantage.

In this environment, there are two options for building societies. Either you consolidate as Chelsea and Yorkshire now plan to do – there have already been a series of similar mergers – or you give up competing as a large financial services business and go back to your roots, with basic products for the local community.

This polarisation is what Alistair Darling's Treasury wants. It is in favour of there being a handful of large mutuals and a greater number of very small institutions (next week's pre-Budget report will even include reforms to help the latter societies share back-office functions).

But while the Treasury is entitled to its view of how the building society sector should evolve, it is unfair to force it down this route through regulation that is ostensibly about addressing the problems of the credit crunch. To be fair, the Treasury is also working on more honest proposals for building societies (not that the mutual sector likes them much). One idea is that each society has its activities restricted according to regulators' judgements of their size and competence. The smallest players might be limited to only offering low-risk residential mortgages.

Over the past decade, the number of building societies has almost halved in the UK. In the sort of regulatory environment currently being pursued by the Treasury and the FSA, Chelsea and Yorkshire will be far from the last large merger in the sector, while many of the smallest institutions will simply disappear.

One irony of the credit crunch looks set to be that the large banks, which plunged the world close to financial meltdown, have almost all survived the crisis, while the mutual movement, largely blameless, will be purged by a regulatory backlash.

That is disappointing for customers. It would be over-simplistic to say that building societies, with no shareholders to keep happy, always offer a better deal than the banks. But with many of the most positive developments in retail financial services – from free banking to more sympathetic treatment of customers in debt – mutuals have lead the way.