The Co-op and Lloyds: why the marriage is off

"I've already got the shirt off their back and their cufflinks," he declared, paraphrasing press coverage of the time. Eight months later, just weeks before his retirement after 40 years of service, he announced rather less exultantly that the deal was off. After nearly four years in the offing, to save Private Eye the bother of making the pun, what was Verde is now officially Merde.

The Co-op has come in for some stiff criticism this week for flip-flopping on the deal, having wasted nearly £60m in the process. It has undoubtedly enraged the UK government, which saw the group as its best chance to create a challenger bank that would help revive lending activity.

The deal goes to the heart of the UK's financial crisis, specifically our dysfunctional banks. The sale was decreed by the European Commission in 2009 to counterbalance the UK government's £21bn bailout of Lloyds in the wake of its disastrous HBOS merger.

Still 39% owned by the taxpayer as a result, starting the sale process was one of the first actions of Antonio Horta-Osorio, Lloyds' Portuguese chief executive, when he arrived to begin the clean-up job two years ago. In his previous role as head of Santander UK, he had only just inked a £1.65bn deal with Royal Bank of Scotland to buy the 316 branches that the Scottish institution was having to sell as part of its own £45bn government bailout.

Ironically, that deal collapsed a few months ago too. What was put together in swift desperation by the then Labour government in the worst days after the collapse of Lehman Brothers is proving alarmingly difficult to unpick.

Horta-Osorio was not inundated with bidders when Lloyds put the Verde package under the hammer for a mooted £1.5bn. The other front-runners were private equity firm Sun Capital Partners, the vehicle of Pizza Express and Punch Taverns founder Hugh Osmond; and NBNK ("New BaNK") Investments, fronted by City grandee Lord Levene, which had been set up after the financial crash by a number of leading finance companies to buy banking assets on the cheap with a view to forging a new retail player.

Sun fell first because its bid was not competitive enough. NBNK was also in the running for Northern Rock, but lost out to Virgin Money in November 2011. When it emerged the following month that Lloyds had chosen the Co-op as its preferred bidder, NBNK chief executive Gary Hoffman did not hold back.

"Lloyds has made the wrong decision," he said. "There is no question that the execution risk with the Co-op is much more significant, and over a very short period of time this will be proven."

Stories began to appear in early 2012 that City watchdog the Financial Services Authority was dragging its heels over regulatory approval. NBNK offered a new proposal in April for Lloyds shareholders that would have seen the Verde branches floated on the stock market, with NBNK underwriting the deal, potentially giving it control of the new company if take-up for the listing was weak.

But several months later, Lloyds announced that it was sticking to Plan A. The deal – clearly the government's preferred option – was to create a bank with 7% of the market, with nearly 1000 branches, including 189 in Scotland.

The terms with Co-op were far enough from the original price tag to make Peter Marks's "shirt off their back" comments easily justified. The Manchester-based group would pay just £300m upfront and then a potential £450m as far off as 2027, depending on whether certain targets were reached. Lloyds was also providing the financing for the deal, £1.5bn in capital, the technology platform for the IT system, no transferred pension liabilities – and even the manager, Paul Pester, who would become the new head of the Co-op Bank. In total, the disposal would cost Lloyds about £1bn – telling you everything you need to know about how unfancied UK banking assets are at the present time.

Even then, bank experts were growing increasingly worried the deal would fall through, despite the fact that the Co-op had swallowed Somerfield and the Britannia Building Society in recent years. They didn't like the announcement last December that Marks was being replaced by Euan Sutherland, a Scot from B&Q with no background in banking. Nor did they like the unexpected sequel in February when it was announced that James Mack, the bank's finance director and the other key architect of the deal, was unexpectedly departing too.

This was shortly followed by a lousy set of annual results that showed the supposedly ethical bank posting a £600m pre-tax loss that included bad loans, provisions for mis-selling payment protection insurance and a massive writedown of the IT system.

Then came speculation that, despite the Lloyds package, the Co-op Bank would need to find £1bn in capital to meet the incoming tougher rules in the UK and European Union aimed at protecting the banks (and hence the taxpayer) from future collapses. Not surprisingly, one well-placed source concludes: "Everybody knew that the deal was going to fall apart for a while."

The group blamed its decision on the "current economic environment, the worsened outlook for economic growth and the regulatory requirements on the financial services sector in general".

But most commentators dismissed the economy justification on the grounds that the picture has not changed much since last summer, and said in reality it boiled down to regulation – the Co-op couldn't afford the extra capital required to have a bank with 7% of the retail market.

This is despite the fact that it has just sold its life insurance business to Royal London for £219m and is planning to sell the rest of its insurance interests, too. Speculation is rife that the Co-op will seek to ditch its roughly 2% market share and walk away from banking altogether.

However, Louise Cooper, a former Goldman Sachs executive who blogs at Coopercity.co.uk, thinks the group deserves more credit.

"It was quite a ballsy move. All their advisers in the City would have been putting massive pressure on them. They only get paid if the deal goes through, so they would all have been saying, 'It's a great deal'.

"Chief executives never walk away. But it's what Lloyds should have done over HBOS; it's what RBS should have done with ABN Amro."

Richard Reid, an honorary research fellow at Dundee University and an expert on banking regulation, can believe that the new chief executive will decide to leave banking behind, however.

He said: "With higher capital requirements, higher lending costs and a very low interest rate environment, that makes it harder for banks to make profits. This sort of prolonged exposure to difficult conditions is where you get a lot of businesses asking themselves if they want to stay in a sector. It's probably going to be the case that, unless your business operations are extremely efficient, you won't be competitive in banking."

Meanwhile, Horta-Osorio has confirmed that the Verde branches will now be rebranded with the old TSB (Trustee Savings Bank) moniker and listed on the stock market. Despite the fact that the RBS spin-off branches look likely to list around the same time – branded as William & Glyn's, another old banking name – some analysts have said that flotation could be a more lucrative exit for Lloyds. There is talk that the share price floor for the listing would be set at £1bn.

Cooper has her doubts. She said: "It's worth more to a trade buyer like the Co-op that can achieve synergies than to a stand-alone entity. And a trade buyer wasn't willing to spend £750m. However, Lloyds will no doubt tie up every major investment banker in the City so that everyone is writing positive research, so we'll see."

Until then another dismal chapter in British banking comes to a close. Whatever happens next in this saga, all bets are off.