Fitch has cut Co-operative Bank from A- to BBB+ because of asset quality deterioration, and kept its rating on Rating Watch Negative to reflect the likelihood of a downgrade following finalisation of a planned takeover of 632 Lloyds Banking Group branches.

The rating agency also cut Co-operative Bank’s Viability Rating (VR) from a- to bbb+ and placed this on Rating Watch Negative (RWN). A support rating of 3 and support rating floor of BB+ were placed on Rating Watch Positive (RWP). The rating actions were carried out on Friday.

The downgrades reflect deterioration of Co-operative Bank’s asset quality, according to Fitch, with impaired loans rising to account for a high 9.1% of gross loans at the end of 2011 and the rating agency anticipating further deterioration in 2012. Impaired loan coverage is weak, in Fitch’s view.

“There is significant dependency on property collateral to cover impaired loans, in addition to the buffers of impairment allowances and fair value adjustments, at a time when real estate values remain under downward pressure,” it added.

It also said that over the medium term, capital will be negatively influenced by the unwinding of significant fair value adjustments made for legacy Britannia Building Society (Britannia) debt securities when Co-operative Bank merged with it in 2009.

“These adjustments were positive on the merger date and as they unwind, they will have a negative impact on equity over the medium term,” said Fitch.

The rating agency placed the Issuer Default Rating (IDR) and VR on RWN to reflect the likelihood of it further downgrading them if a planned sale and purchase agreement with Lloyds Banking Group (LBG) plc is finalised.

Co-operative Bank is set to take over 632 branches from Lloyds Banking Group in a deal said to be the biggest shake-up of UK high street banking in a generation, with the two banks on Friday announcing that they have agreed non-binding heads of terms for the acquisition of Lloyds’ Verde business, and are working towards agreeing definitive, binding documentation. According to Co-operative Bank, the transaction is expected to be completed before the end of November 2013 and will be conditional on, among other things, regulatory approvals from the FSA, HM Treasury and the European Commission.

Fitch said that it would probably downgrade the Issuer Default and Viability ratings on the announcement of a sale and purchase agreement, and that after a sale and purchase agreement and even after completion it might maintain the ratings on RWN depending on how the significantly enlarged resultant business performs and the accounting implications of the transaction.

It said that the potential acquisition is sizeable and, if completed, could potentially lead to around 50% growth of Co-operative Bank’s balance sheet.

“Management has maintained that it does not have appetite to weaken Co-operative Bank’s capitalisation or funding position as a result of the acquisition, which is consistent with the heads of terms agreement that LBG will capitalise the balance sheet and that there would be no funding gap,” said the rating agency.

“Fitch continues to believe that there are execution and integration risks associated with the transaction, particularly relating to asset quality development and the burden on management. Other risks facing Co-operative Bank include customer attrition and risks related to the future migration of existing Co-operative Bank customers.”

However, Fitch said that it expects that the acquisition will ultimately be positive for the group, particularly if integration risks are well managed and if legacy problem loans are dealt with effectively and swiftly.

“It is Fitch’s view that the enlarged franchise combined with the current political pressure to create an effective competitor within the banking system may result in a higher Support Rating Floor, possibly at BBB-, which would be the lowest level the long-term IDR could reach if the bank’s VR is downgraded further.”