The supply of banking services by clearingbanks to small and medium-sized enterprises

A report on the supply of banking services by clearing banksto small and medium-sized enterprises within the UK

Volume 3: Background Chapters 8–13

COMPETITION COMMISSION

The supply of bankingservices by clearing banksto small and medium-sized enterprises

A report on the supply of banking services byclearing banks to small and medium-sized enterpriseswithin the UK

Volume 3: Background Chapters 8-13

Presented to Parliament by the Secretary of State forTrade and Industry and the Chancellor of theExchequer by Command of Her MajestyMarch 2002

© Competition Commission 2002

Web site: www.Competition-Commission.org.uk

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Volume 3 contents

Page

Chapter 8 Views of third parties..................................................................................................1

9 Views of smaller clearing banks.............................................................................. 77

10 Views of Barclays.................................................................................................. 179

11 Views of HSBC ..................................................................................................... 253

12 Views of Lloyds TSB ............................................................................................ 345

13 Views of RBSG ..................................................................................................... 409

List of signatories................................................................................................... 468

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Note by the Department of Trade and Industry

In accordance with section 83(3) and (3A) of the Fair Trading Act 1973, the Secretary of State and theChancellor have excluded from the copies of the report, as laid before Parliament and as published, certainmatters, publication of which appears to the Secretary of State and the Chancellor to be against the publicinterest, or which they consider would not be in the public interest to disclose and which, in their opinion,would seriously and prejudicially affect certain interests.

The omissions are indicated by a note in the text or, where space does not permit,by the symbol ✄✄✄✄.

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8 Views of third parties

ContentsPage

Introduction................................................................................................................................................. 4Regulatory authorities................................................................................................................................. 4

Bank of England ..................................................................................................................................... 4Hypothetical remedies......................................................................................................................... 7

Financial Services Authority................................................................................................................... 8Banking Review Team............................................................................................................................ 8

Profitability ....................................................................................................................................... 10The market and competition ............................................................................................................. 11Possible remedies.............................................................................................................................. 13

Other banks ............................................................................................................................................... 13Airdrie Savings Bank............................................................................................................................ 13Bank of Cyprus (London) Ltd............................................................................................................... 13Crédit Lyonnais (UK) ........................................................................................................................... 14Halifax plc............................................................................................................................................. 14C Hoare & Co ....................................................................................................................................... 16Lazard Bank Limited ............................................................................................................................ 16Northern Rock plc................................................................................................................................. 16Robert Fleming & Co Limited .............................................................................................................. 16Standard Life Bank ............................................................................................................................... 17Sun Bank PLC....................................................................................................................................... 18Tesco Personal Finance Limited ........................................................................................................... 18Triodos Bank NV.................................................................................................................................. 18Whiteaway Laidlaw Bank Limited ....................................................................................................... 20Woolwich plc ........................................................................................................................................ 21

Building societies...................................................................................................................................... 21The Chesham Building Society............................................................................................................. 21Derbyshire Building Society................................................................................................................. 21Furness Building Society ...................................................................................................................... 21Kent Reliance Building Society ............................................................................................................ 21The Mansfield Building Society ........................................................................................................... 22Monmouthshire Building Society ......................................................................................................... 22Newbury Building Society.................................................................................................................... 22Newcastle Building Society .................................................................................................................. 22Norwich and Peterborough Building Society........................................................................................ 22A building society ................................................................................................................................. 23

Other financial organizations .................................................................................................................... 23Association for Payment Clearing Services .......................................................................................... 23Anglia Business Associates Ltd ............................................................................................................ 24Bibby Group of Factors Limited ........................................................................................................... 26Close Invoice Finance Limited ............................................................................................................. 27Earthport plc ......................................................................................................................................... 27Five Arrows Commercial Finance Limited........................................................................................... 28GMAC Commercial Credit Limited ..................................................................................................... 28The Post Office ..................................................................................................................................... 29RDM Factors Limited ........................................................................................................................... 29Visa International Service Association ................................................................................................. 29

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Chambers of Commerce ........................................................................................................................... 30Ashford (Kent) Chamber of Commerce, Industry & Enterprise ........................................................... 30Bolton & Bury Chamber of Commerce ................................................................................................ 30British Chambers of Commerce............................................................................................................ 31

Hypothetical remedies....................................................................................................................... 33Dorset Chamber of Commerce & Industry ........................................................................................... 34Dover & District Chamber of Commerce & Industry........................................................................... 34Mid Yorkshire Chamber of Commerce & Industry Limited................................................................. 34Northamptonshire Chamber of Commerce ........................................................................................... 37Oldham Chamber of Commerce, Training & Enterprise ...................................................................... 38

Trade associations, SME representatives and advisory bodies ................................................................. 38Association of Convenience Stores Ltd ................................................................................................ 38

Remedies........................................................................................................................................... 39Possible regulation of charges, terms, conditions or profits.......................................................... 40Behavioural remedies to remove barriers to entry ........................................................................ 40Behavioural remedies to safeguard SMEs in their relationship with banks .................................. 41A possible tax, licence fee or fund ................................................................................................ 41Possible structural remedies.......................................................................................................... 41

Bank Mediation Services ...................................................................................................................... 42Brandenburg Securities Ltd .................................................................................................................. 43British Bankers’ Association ................................................................................................................ 45

Possible regulation of charges, terms, conditions or profits.............................................................. 45Possible behavioural remedies primarily to remove barriers to entry ............................................... 46Possible behavioural remedies primarily to safeguard SMEs in their relationships with theirbanks ................................................................................................................................................. 47

A possible tax, licence fee or fund ................................................................................................ 48British Cheque Cashers Association ..................................................................................................... 49British Retail Consortium ..................................................................................................................... 49Business Link Isle of Wight Limited .................................................................................................... 51Business Link Sussex Ltd ..................................................................................................................... 52The Campaign for Community Banking Services ................................................................................ 52

Possible remedies.............................................................................................................................. 53Factors & Discounters Association....................................................................................................... 54Federation of Small Businesses ............................................................................................................ 57Global Consulting (UK) Ltd ................................................................................................................. 59Independent Banking Advisory Service................................................................................................ 60Institute of Directors ............................................................................................................................. 60

Hypothetical remedies....................................................................................................................... 60Possible regulation of charges, terms, conditions or profits.......................................................... 61Possible behavioural remedies to reduce or remove the barriers to entry ..................................... 61Possible behavioural remedies primarily to safeguard SMEs in their relationships with theirbanks ............................................................................................................................................. 63A possible tax, licence fee or fund ................................................................................................ 63Structural remedies ....................................................................................................................... 64

National Farmers’ Union ...................................................................................................................... 64The Forum of Private Business ............................................................................................................. 64

Transaction charges .......................................................................................................................... 64Collateral when borrowing................................................................................................................ 65Margin when borrowing.................................................................................................................... 65Availability of credit ......................................................................................................................... 65The 2000 survey................................................................................................................................ 65Comments on Issues Letter ............................................................................................................... 66

The monopoly situation ................................................................................................................ 66Competition................................................................................................................................... 67Relations with customers .............................................................................................................. 68

Possible remedies.............................................................................................................................. 68Finance & Leasing Association ............................................................................................................ 69The Small Business Agency.................................................................................................................. 71A former bank employee....................................................................................................................... 71

The possible complex monopolies .................................................................................................... 71Issues................................................................................................................................................. 72

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Market definition .......................................................................................................................... 72Effectiveness of competition......................................................................................................... 72Profitability and prices .................................................................................................................. 73Relationships between SMEs and clearing banks ......................................................................... 73

Possible remedies.............................................................................................................................. 74Individual small businesses....................................................................................................................... 74

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Introduction

8.1. This chapter summarizes the views of third parties. In addition to those third parties whoseviews are summarized below, we heard from a significant number of other banks and building societies.Many of these told us that they did not currently provide the reference services, as it was not theirstrategy to do so or the focus of their business was elsewhere: we have only included their views of anyspecific factors in the market which deterred them from providing the reference services. With regard tobanks and building societies currently offering the reference services, we have included below only thosewho provided views on aspects of the market, but elsewhere in the report we have taken into account thestatistical information provided to us on the scale of their activities.

Regulatory authorities

Bank of England

8.2. The BoE’s interest in the financing for SMEs stemmed from its remit to promote the efficiencyand effectiveness of the UK financial system. This meant monitoring and analysing the way in which thefinancial system supports the wider economy, including the SME sector. The BoE recognized theimportant contribution that SMEs made to the UK economy, not just in terms of economic impact—accounting for over 50 per cent of employment and output—but in their capacity for specialization andtheir ability to respond quickly to the needs of the marketplace.

8.3. In the early 1990s the BoE was asked by the then Chancellor of the Exchequer to examinewhether banks were passing on benefits of base rate reductions to their small business customers. TheBoE collected data from seven major banks then involved in lending to SMEs during the summer of1991 and autumn 1992. The results showed that between June 1991 and November 1992, 70 per cent ofcustomers had received at least the full reduction in base rates. Of the 30 per cent of accounts that sawmargins widen, half had increased by less than 0.5 per cent. The average margin over base rate, weightedby debit balance, was less than 3 per cent, which seemed broadly in line with loan loss experience.

8.4. The BoE believed that during the recession of the early 1990s there was evidence of a break-down in communication and trust between small firms and banks. The banks had large exposures to thesmall business sector and had made substantial losses as a result of the recession. This posed a financialand reputational threat to the banking sector, as well as exerting a destabilizing effect on small busi-nesses. It also highlighted deficiencies in relationships and information sharing between banks and theirsmall business customers. The BoE’s work during the last nine years had focused on these issues, andhad covered the whole range of finance available to SMEs, not merely bank finance.

8.5. Since 1992 the BoE had consulted regularly with the SME community, through SME represen-tative organizations and the business contacts of its regional agents. The BoE had also maintained adialogue with finance providers, academics and those with a policy interest in the area. In addition toregular liaison, the Governor hosted a seminar each year to bring together groups of interested parties,and the BoE produced an annual report: the eighth edition of which was published in 2001. SMEs werenot a homogeneous group and their financing needs varied. The BoE had aimed to cover the SME popu-lation as a whole but had tended to focus primarily on smaller firms.

8.6. The availability of finance was often at least as compelling a consideration for small firms as itscost, with a number of factors affecting it. Smaller firms tended, during a recession, to be more vulner-able to the economic climate than their larger counterparts. Lenders might cut back on exposures beyondwhat was quantifiably justified by the risks involved. In the last recession excessive and indiscriminatelending in the late 1980s had led to problems between banks and small firms. As a result the majorclearing banks had to make provisions of around £3 billion against this part of their loan book, althoughnot all these provisions crystallized as losses.

8.7. The BoE believed that banks had now adopted more discerning lending policies and improvedcredit-scoring techniques as well as sophisticated systems that detected at an early stage when businesseswere encountering trading difficulties. The overall quality of the banks’ loan books had improved sig-

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nificantly, which was reflected in the decline in the level of provisions against small business lending.(The BoE believed that this suggested a reduced likelihood of a sudden reduction in the availability ofcredit or difficulties in relationships between banks and SMEs than was the case in the early 1990s.)

8.8. The BoE believed that small firms had a higher probability of ceasing to trade than large firmsand lending to them was therefore likely to involve a greater degree of risk. Evidence based on VATderegistrations showed that small business closures occurred throughout the economic cycle, withslightly less than half the businesses closing in their first three years irrespective of economic conditions.Banks often chose to take collateral in order to mitigate these risks. Studies showed that the availabilityof debt finance to small firms was affected by the size and value of the assets which could be taken ascollateral. The Small Firms Loan Guarantee Scheme, set up in 1981, had been useful for small firms con-strained by lack of collateral or with no track record.

8.9. The BoE felt that small businesses had traditionally relied on overdraft facilities to financeanything from working capital to long-term investment projects. There had since been an acknowledge-ment of the need for appropriate forms of finance, for example a recent marked shift towards term loans.A small business might require a ‘package’ of finance, tailored to its individual requirements. This hadresulted from SMEs switching to, for example, asset-based finance and substituting these forms offinance in circumstances in which they would have traditionally used bank finance.

8.10. The BoE had found that UK small firms were less dependent on external financing than in thelate 1980s. Research by the ESRC Centre for Business Research in Cambridge had shown that only39 per cent of small businesses sought external financing of any kind between 1997 and 1999, comparedwith 65 per cent in the 1987 to 1990 period. The proportion of external finance for small businessesaccounted for by traditional bank borrowing had also declined, from 60 per cent in the 1987 to 1990period to 48 per cent between 1995 and 1997. However, between 1997 and 1999 it had grown again to61 per cent. Rejection rates were lower for bank finance between 1994 and 1995 than for the 1991 to1993 period, suggesting that the reduction in the relative importance of bank finance in the mid-1990swas demand rather than supply driven. In the 1997 to 1999 period, when the relative importance of bankfinance recovered, the Cambridge research rejection rates fell further to 10 per cent.

8.11. The characteristics of bank finance in the UK had changed considerably during the 1990s.Bank lending to the SME sector had started to increase again, having fallen consistently from 1992 to1996. The ratio of overdrafts to term lending had fallen significantly since early 1992 (49:51) and stoodat 32:68 in March 2001. This shift away from overdraft financing to committed funds with fixed repay-ment streams had reduced small firms’ vulnerability to the economic cycle. Small businesses had, sincethe mid-1990s, also gradually increased their use of fixed-rate loans. This trend was advantageous formany SMEs as fixed-rate loans provided them with greater certainty of expenditure streams, assistingbusiness planning and enabling businesses to operate in a more assured financial environment.

8.12. The net bank indebtedness of the SME sector had continued to fall. This reflected the markedupward trend in deposits, which reached a record high of £41.2 billion in December 2000. The ratio ofdeposits to lending was 102 per cent in March 2001, compared with 56 per cent in December 1992.

8.13. In addition to the changes in the structure of bank finance, UK small businesses now madegreater use of non-bank forms of finance, such as factoring, leasing and, to a limited extent, equity.Factoring and invoice discounting provided businesses with access to finance against their outstandinginvoices. These forms of finance were particularly appropriate for small growing firms and for exportersunable to draw on further overdraft facilities. Factoring and invoice discounting activity was highly con-centrated in the UK, with 58 per cent of activity in 2000 accounted for by the top four firms, three ofwhich were owned by UK clearing banks.

8.14. Since the last recession, the proportion of external finance to UK small businesses accountedfor by leasing and hire purchase had grown significantly, to an extent replacing traditional bank financeand was greater than the EC average. Research had found that SMEs used leasing as a substitute for debtfinance and that 50 per cent of SMEs used leasing amounting to 19 per cent of their total debt. UK banks,through their factoring and asset-based finance arms, accounted for a significant proportion of thismarket.

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8.15. Venture capital, which played an important role in financing those growth-orientated firms thatit supported, accounted for just 1 per cent of external finance for SMEs in the period 1997 to 1999. TheUK also had a growing informal venture capital market, with business angels playing an increasinglyimportant role in filling the gap between debt finance and formal venture capital. The business angelmarket was largely invisible, although research by Harrison and Mason estimated that the UK hadapproximately 18,000 business angels and that they annually invested in the region of £500 million.Participation by the banks in this market included sponsorship of the National Business Angel Networksand a number of investments alongside business angels.

8.16. The BoE had identified real improvements in the relationships between finance providers andtheir SME customers. Banks had learnt from the last recession the importance of training staff to dealwith the particular needs of small businesses (particularly for credit) in an efficient and cost-effectiveway. Banks had since devoted substantial resources to increasing the awareness and skills of lendingmanagers and staff at branch level, and many had introduced sectoral specialists. For their part, smallfirms had increasingly understood that finance providers would benefit from up-to-date financial infor-mation. This had enabled banks both to improve the quality of their loan books, and to develop betterrelationships with their SME customers.

8.17. The BoE cited evidence that banking transaction charges had fallen consistently since 1992,with many banks freezing their fee structure. However, small businesses still cited charges as one of themain driving forces behind bank switching. This could reflect the fact that charges appeared to be morerigorously enforced now than in the past. Research showed, however, that only 4 per cent of small busi-nesses had changed their bank in the past year, rising to 15 per cent for the past five years. The BoEbelieved it was necessary to take account of the importance that SMEs placed on the quality of servicesand on building long-term relationships with their finance providers; banking services were notnecessarily price sensitive partly because they accounted for a very small amount of SMEs’ total costsand lower costs elsewhere were often not a compelling enough reason for a small business owner tochange bank. In general real improvements in the relationship between finance providers and their SMEcustomers had been identified. Measures to increase transparency on bank charges would be a positivestep for small firms. Concerns had also been expressed at the number of errors made by banks in assess-ing charges.

8.18. The latest data supplied to the BoE suggested that the mean margin over base rate for smallbusiness lending during the second half of 2000 was approximately 2.75 per cent. Margins had remainedfairly stable over the past five years and prices reflected the risks involved in the SME lending market.The proportion of total bank income from small businesses attributable to fees and charges variedbetween the banks, ranging from just under 20 per cent to just over 40 per cent.

8.19. The BoE believed there was little evidence that SMEs currently had difficulty accessing debtfinance from banks. Recent survey evidence reached the same conclusions.

8.20. New technology was increasing the range of facilities available in small business banking, forexample telephone banking, which offered customers banking services outside normal working hours,and PC and Internet banking services. There was evidence that the take-up of PC and Internet bankingwas increasing.

8.21. This was an industry of very large set-up costs; to provide a full banking service to SMEsrequired, for example, volume, ability to spread risk, and need for a track record and reputation. A degreeof concentration was not therefore surprising. However, there was scope for entry by ‘cherry picking’particular bits of the business, assisted by the diversification by small businesses in supply of finance; forexample, a greater use of asset finance etc, at the expense of overdrafts traditionally supplied by the mainbanks. Hence the BoE believed that the small business banking market had not been devoid of newentrants. Abbey National and its subsidiary First National had both entered the market. Telephone andInternet banking reduced the need for extensive branch networks and should make entry to the smallbusiness banking market easier.

8.22. The BoE concluded that it found little evidence that SMEs had any real difficulty accessingdebt and other forms of bank finance.

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Hypothetical remedies

8.23. Commenting on the hypothetical remedies, the BoE reiterated that, based on its contacts withthe providers of finance to SMEs and the SME community, it considered that SMEs in recent years hadfaced little real difficulty in borrowing from banks or accessing other forms of bank finance; and,perhaps more significant in the present context, that relationships between banks and their SME cus-tomers had improved significantly since the early 1990s. Although the main focus of its work had beenthe provision of finance rather than the provision of banking services generally, it was neverthelessstriking that it had heard relatively little from small firms or their representative bodies about the latter.

8.24. With that background in mind, the BoE was surprised by the CC’s provisional conclusions andhad serious misgivings about several of the hypothetical remedies.

8.25. The complex monopoly findings related primarily to the terms and conditions attached to smallbusiness current and deposit accounts and to money transmission services, rather than to the provision ofloans and other debt finance to SMEs. This accorded with the BoE’s own assessment that SMEs had fullaccess to bank finance on broadly reasonable terms and conditions. In view of this, the BoE believed thatthe provisional conclusions that terms and conditions in the SME banking market were more restrictivethan would emerge under fully competitive conditions, and that charges were unrelated to costs, neededfurther justification or qualification.

8.26. As for the hypothetical remedies, the first set—involving possible regulation of charges, terms,conditions and profits—seemed to envisage a significant element of control over banks’ commercialoperations and relationships with their customers. The BoE had serious misgivings about such detailedintervention, which could damage rather than improve the provision of SME financing, which was itsmajor concern, and deter entry. Rather than a requirement to pay a specified rate of interest on currentaccounts, such matters should be driven by market forces, as was the case with Halifax’s and others’recent moves to pay interest on current accounts in the personal market. This would possibly be assistedby transparency and encouraging SMEs to shop around, particularly those requiring a more basic bank-ing service. If similar market developments occurred in the business market, it could reduce any cross-subsidy between deposits and loans; but the take-up of that development would then be a matter forchoice by individual firms. The BoE believed that if payment of interest on current accounts led to a shiftfrom deposit to current accounts, there would not be any significant effect on banks’ liquidity require-ments or on the money markets. Any effects could be fairly small, because just over 60 per cent of SMEdeposits were already in no-notice accounts and the remainder accounted for only about 3 per cent ofmajor British banking group sterling sight deposits and only about 2 per cent of sterling time deposits.Moreover, liquidity requirements were based not just on the formal legal terms of an account but had avery strong behavioural element.

8.27. The BoE had more sympathy with the remedies proposed to increase competition: to removebarriers to entry, improve transparency in the market and facilitate switching. On this last point, however,it had little evidence that banks had conspired to make switching more difficult: indeed, if anything, theyappeared to be taking action to reduce the cost of switching and low switching might reflect SMEs’ satis-faction within their existing suppliers. Some of the remedies designed to safeguard SMEs in theirrelationship with banks seemed sensible, to the extent that they succeeded in improving transparency ofpricing. Again, however, the banks were taking on board many of the remedies through their develop-ment of the proposed new Code of Conduct for Business Banking. The BoE was also not aware of anyconclusive evidence that banks took excessive or unnecessary collateral in their SME lending; indeed, itsanalysis suggested that a greater proportion of banks’ lower-value lending to SMEs was now unsecured.It was also concerned that some of the remedies, for example a ban on discriminatory prices or onrequirements that SMEs maintain a business account as a condition for a loan, could put at risk therelationships between banks and SMEs that were of benefit to both sides. Such relationships allowed thebanks to monitor cash flow and better to assess credit and offer appropriate services: it was because ofsuch relationships, rather than lack of competition, that many SMEs were reluctant to change supplier.

8.28. On a possible tax or licence fee on banks’ excess profits and divestment of branches or busi-nesses in certain areas, neither would, in the BoE’s view, improve the provision of finance to SMEs orencourage new entry into the market; if anything, they would both have the opposite effect.

8.29. Most of the hypothetical remedies seemed unlikely therefore to lead to greater competition orto facilitate new entry, as the CC itself appeared to recognize in some of its own comments.

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Financial Services Authority

8.30. The FSA gave us considerable background information concerning regulation of the bankingsector. It also provided us with more specific information on regulatory capital requirements of differentbanks.

8.31. The FSA was able to provide us with composite information covering seven ‘players’ withmaterial loans to unincorporated businesses, and 28 ‘potential players’ either with minimal SME lendingat present and/or considered likely to be interested or have capacity to participate in the market. Theplayers were estimated to account for some 92 per cent of current overall estimated SME lending andpotential players some 7 per cent. The overall estimated SME lending, however, would currently amountto around 2 per cent of the 35 banks’ balance sheets. Although the players were generally the largerbanks, there were several potential players of similar size.

8.32. In general terms, larger banks on average had lower regulatory capital ratios and smaller bankshad higher ratios. This was largely explained by larger banks generally having more professionalmanagement; the capacity to invest in and maintain higher-quality systems and control risk management;and more diversified business and greater ability to withstand losses in parts of their business. Theplayers, therefore, being on average larger institutions, had slightly lower regulatory ratios. However,potential players did not uniformly have higher ratios and the average for this group was only onepercentage point higher. Moreover, both groups currently had actual capital ratios significantly abovetarget: 3.9 percentage points for potential players compared with 2.5 percentage points for players. Thisextra margin suggested that having a higher regulatory ratio was not generally a business constraint, atleast currently.

8.33. Finally, were the potential players to raise their lending to SMEs to a level equivalent to theaverage for players, their actual capital ratios would decline by less than one percentage point. This couldbe absorbed comfortably within their current margins of capital held above regulatory requirements.

Banking Review Team

8.34. At an early stage of the inquiry, we had a hearing with Mr Don Cruickshank and othermembers of the Banking Review Team (BRT). The clearing banks also provided us with copies of corre-spondence between themselves and the BRT.

8.35. As to the definition of SMEs, the BRT took those firms—almost all limited liability firms,although a few individuals might be included—which were no longer treated as personal customers byproviders of money transmission services and credit. In other words, the firm had moved from its creditassessment being based on its history as a person, but too small to have direct access to competitivecapital markets. There were about 1.3 million such businesses in the UK that were by and large a captivemarket for the clearing banks in terms of their access to money transmission and to a number of relatedservices and debt in various forms. The 1.3 million approximates to firms with up to about 250employees.

8.36. The 1.3 million would largely exclude sole traders and partnerships. The Treasury, InlandRevenue and HM Customs and Excise data about how many firms up to 250 employees paid or receivedVAT gave about 900,000 firms. The precise number did not matter because it was the characteristics ofthe relationship between provider and customer that were the concern in analysing competition.

8.37. The BRT said that such SMEs represented some 40 per cent of this country’s private sectorGDP. They were the source of much of the country’s job creation and, increasingly, innovation: hencethe importance of the CC’s investigation. As in almost any other sector of the economy, those who ran orowned small businesses generally took the view that the clearing banks were all the same and had higher-priority things to do than worry about whether their charges for money transmission systems of one formor another could be reduced. They rarely gave active consideration to switching, as shown by theevidence of switching and what they said about the number of times they looked at alternatives. This was

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a group of consumers subject to service by a limited number of organizations in a situation where therewas huge information asymmetry between clearing banks and the individual small firm. Uncertaintyabout how the clearing bank would behave in uncertain circumstances in the future also had a significanteffect on the relationship between banks and SMEs. This was a group that probably did not know thatthey were being badly served. Hence although surveys showed relatively high satisfaction with clearingbanks, this was because customers were unaware of the improvements that could be provided.

8.38. There was no single indicator that suggested there was a problem. The BRT believed that theevidence of profitability and about pricing structures showed systematic cross-subsidy between moneytransmission services, that were the monopoly of the banks, and lending, which was not necessarily abanks’ monopoly, a cross-subsidy that distorted competition in both markets. By underpricing debt, theclearing banks made it less easy for pure debt providers to enter the market. There were other linkagesbetween the banks’ central products, namely overdrafts and debt, and other sources of finance, such asfactoring, where, not insignificantly perhaps, the banks also had very large market shares.

8.39. In Chapter 3 of its report, the BRT recommended that there should be systematic regulation ofbank money transmission systems. The distortion of competition identified, which led to the recommen-dation of a payments system commission (PayCom), existed in extreme form in the provision of servicesto SMEs which were proportionately, by and large, much heavier consumers of money transmissionsystems than personal consumers. The issues surrounding money transmission were therefore alsorelevant to our inquiry.

8.40. Also relevant to our inquiry from Chapter 2 of the Cruickshank report were the economicbarriers to entry to small business banking, which were higher than for personal or large corporate banks,given the difficulty in getting a banking licence on terms that were economic for people who mightfinance that bank. Smaller players, particularly those coming to the market, were required to hold higherlevels of regulatory capital than those who were established, because, being new, they did not have atrack record, and therefore the FSA found it difficult to assess how risky they were. That distinguishedthe UK sharply from the USA, although it was difficult to reach an independent view on whether theregulatory capital requirements were higher than appropriate. In the USA, quite a small firm couldoperate and reduce its cost base through outsourcing and other arrangements, and the greater degree ofregulatory supervision in the USA, with regulators physically located in the banks, could be used toovercome some of the uncertainties of start-up companies. This did not apply in the UK.

8.41. The main reason, however, that small business banks developed in the USA was the applica-tion of structural rules at a local level as to broadly what market share any individual bank could have insmall business lending, so that in the event of a merger there were quite often spin-offs of branches andcustomers.

8.42. There were some banks in the USA, therefore, which were single-branch, essentially business,banks, which lent only to businesses within half an hour’s walk of the only branch. Some of those werenew and were created usually as a result either of some form of merger or because a lending manager inan existing bank thought that he could do a better job than in his existing bank, so he created a new bank.The banking market in the USA seemed to have captured a means of generating local knowledge andaggregating it in ways which allowed new entry or change of ownership in the local market, togetherwith access to economies of scale in a whole number of outsource functions, enabling them to operatewith only one or two branches.

8.43. In the UK, on the other hand, all the new entrants over the last five years had been either injoint ventures with a bank, or a subsidiary of an insurance company which undertook deposit businessanalogous to a bank: suggesting that organization and procedures in the UK were very risk averse.

8.44. A number of obstacles also operated against the efficient outsourcing of the back office, whichdistinguished the UK from the USA and made it less easy for the small banks to access the economies ofscale of cheque handling. One was the access of non-banks to the underlying money transmission systemon what seemed to be unfair terms; the second was the fact that VAT might be charged on handlingcheques by a non-bank but not by a bank, hence a 17.5 per cent penalty for subcontracting to a non-bank.On the first of these points, the BRT believed PayCom should establish broad rules of access to moneytransmission systems, ie that access should be on fair and reasonable and non-discriminatory terms,rather than needing detailed regulation. This would include use of branches of other banks.

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Profitability

8.45. There was evidence in the Cruickshank report of returns significantly higher than the cost ofcapital. Asked about the argument that surviving firms might be expected to have, on average, returnshigher than the cost of capital because the ones that had lower return were not observed, the BRT saidthat there were very few banks which did not survive, in part because entry was so difficult and becauseof regulation.

8.46. In analysing profitability, the BRT had, for the purposes of the calculation, accepted all thebanks’ assertions about regulatory capital that should be allocated to personal and small business bank-ing, despite which there was systematic earning of supernormal profits in the personal and small businessmarkets.

8.47. The BRT focused on return on equity since banks had unusual balance sheets, being highlygeared, and their capacity to do business on the asset side, such as making loans, was crucially deter-mined by their willingness to enter into typically short-term liabilities by taking deposits. These depositswere not analogous to an ordinary firm going into the debt market and issuing securities in a competitivemarketplace, but represented in effect the banks’ working capital.

8.48. The operation of taking deposits and lending and having a spread of two and a half or threepercentage points in doing so was akin to the production of a service or a product. It was that whichgenerated a margin that, net of cost, generated a profit: the cost of deposits was effectively an operatingexpenditure. The BRT was aware of no other valid way of assessing the banks’ profitability.

8.49. On the time period over which rates of return should be considered, in the late 1980s a numberof factors—poor credit assessments, a determination to invest all the regulatory capital, plus a significantinformal pressure from the Government to support the UK small business sector—resulted in a loan port-folio which was not economically rational. Since the mid-1990s there had been effective professionalmanagement of risk assessment, effective quality control, and a rigorous focus on only investing in whatwas economic, and to the extent that that was less than regulatory capital, returning that capital to share-holders.

8.50. In estimating the excess profits of services to SMEs, the BRT said that the activities of the11 firms in question in banking outside the UK and in activities outside banking were not the subject ofthe review, but by and large seemed to be competitive sectors, and there was no reason why, system-atically, services such as insurance or international sovereign debt should be anything other than com-petitive. Within UK banking, corporate banking—ie lending to large companies—was also competitive.Logically, therefore, the source of the supernormal profits were the personal and small business bankingmarkets in the UK which, even on the banks’ assumptions, the BRT assessed to be between £3 billionand £5 billion, of which services to SMEs accounted for between £0.5 billion and £1 billion. The mainsource of those excess profits was money transmission and deposits, not debt.

8.51. However, the BRT felt that the disaggregated information given to it of a return on equity fornon-banking and non-UK activities at 30 per cent, given that some of those activities were reported to beloss-making and were in markets which one would expect to be much more competitive than banking,were subject to considerable error and almost certainly overstated. Allowing for that, the rate of return onUK banking would rise.

8.52. These figures included an efficiency adjustment. The BRT believed banks were probably tech-nically quite efficient, but not very good at ensuring that the whole service was provided efficiently. Thepace at which the UK banks were adapting to the opportunities of using new technologies, comparedwith Scandinavia and the USA, was definitely slower, in part because they had market power whichenabled them to dictate the pace of that change because the possibility and the impact of new entry wasmuted. Hence, there was an efficiency gain to be delivered in the UK from a more competitive market-place. The battle for NatWest during the period of the review showed the efficiency savings that wereplanned to be procured, and it was likely that a competitive market would deliver even more.

8.53. On the role of branches, the pattern of consumption of small companies was increasinglydifferent from that of personal consumers. More and more personal consumers were prepared to deal ona distant basis, whereas many small businesses had a need for access, and physically close access, tomoney transmission for depositing cash and cheques. The cost of the physical presence to serve smallbusinesses well would increasingly be borne by small businesses alone.

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8.54. The banks were responding to that, with small business banking centres on the edge of indus-trial estates, not subject to high street rents. There was no cash held in those centres so these were muchcheaper premises from which to conduct small business banking. Hence, the operation of banking ser-vices for small business was being distanced from the branch, except in the crucial area of money trans-mission and access to the capacity to deposit cash.

8.55. The clearing banks were not, however, moving as fast as they could because they correctlyidentified that it was not in their short-term and perhaps medium-term economic interests to change thepattern of consumption of small business. It suited the banks for these to be local markets which a limitednumber of banks had the capacity, the branch network and the skills to cover densely, secure in theknowledge that the small firm needed physical access to a branch of some form, in order to access themoney transmission system, and secure in the knowledge that the information asymmetry, particularlyfor those small firms which wished to borrow money, was such that the small firm would want to beclose to its bank manager.

The market and competition

8.56. The BRT had concluded that it should not include activities such as asset finance and factoringin the same market as the provision of overdraft and term debt. It told us that a firm engaged in assetfinance, in assessing whether to lend to an organization, looked at least as much, if not more, towards theresidual value of the asset in the second-hand market, whether it was at the end of the lease or in theevent of insolvency of the firm, when the asset was retrieved by the asset finance company. Their pricingand attitude to whom they would contract was therefore materially influenced by their assessment ofsecond-hand value of the asset and, to a much lesser extent, the creditworthiness of the firm or theindividual. They were exercising a very different credit and financial analysis from that which a bankwas making in extending overdraft facilities or a term loan.

8.57. Similarly with invoice discounting and factoring, in negotiating a discount at which an organiz-ation would take over the legal responsibility for pursuing and receiving the money for a package ofinvoices, that assessment was being made on the creditworthiness of the customers of the firm, not thefirm.

8.58. In both cases, therefore, the basis of pricing of the form of debt was different, and the actualprice would have very little influence on the price that the banks would charge for overdraft or term debtfacilities to the same firm.

8.59. The trend towards the use of asset finance in particular was very pronounced and very strong.As SMEs became more sophisticated, it was gradually becoming established practice that, having estab-lished an equity base, a firm would then exhaust the possibilities for asset finance before moving to termloans and then perhaps overdraft facilities to deal with short-term fluctuations in cash flow.

8.60. Among the reasons why the BRT reached the view that the market was local was that almostall access to a local facility was essential for firms with a high volume of cash and cheque transactions.Half of businesses used the closest provider for their main source of finance. The median travel timebetween firms’ location and branch used for the money transmission was 8 minutes. Interestingly, firmswere much more likely to be closer if their main source of finance was bank debt: the sense of the needto be close to the local bank manager was stronger the more a firm borrowed. 80 per cent of SMEs wereless than 30 minutes’ travel time from the main provider of finance.

8.61. The main deficiency of potential entrants such as ex-building societies was that they did nothave local information. The investment and the risks that they would have to take to build up a suf-ficiently dense and representative debt book in a local area was much more substantial than mightinitially be imagined.

8.62. Although the clearing banks averred that this was a national market because they exercisednational or at least regional control over their lending decisions, the BRT’s view was that althoughregional centres could veto a local manager’s decision, the response to that was for the bank manager toenter into further discussion with the potential client and go back with another proposal. The banksclaimed both that relationship banking was essential to perform well in this market, and that prices wereset nationally. The transactional history was vital, ie having the money transmission business of the firm

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in question to which no one other than the client’s own bank had access. To ask for it and give it toanother bank so that another bank could make an offer turned out to be difficult. There was also a linkbetween money transmission and debt. If a small business chose its bank by the location of its moneytransmission, then it might automatically go to that same institution for lending because that was where itheld its transaction account.

8.63. The BRT analysed pricing reasonably extensively but could come to no conclusions aboutwhether there were local prices. Pricing of debt was difficult to analyse given the underlying risk assess-ment, which was difficult to factor out of pricing comparisons.

8.64. Almost all the banks’ marketing spend in the small business sector was aimed at the new start-ups, typically with free banking for two years. They spent hardly any money, time or energy in compet-ing for the business of established firms. The BRT suggested that changes in market share of individualclearing banks reflected success in attracting start-ups, not competition for people switching accounts.

8.65. On whether reduction in price in real terms suggested some competitive pressures, thisdepended on the trend in the underlying cost base. There had also been a trend towards charging higherfees, although that was a genuine attempt to be more cost-reflective.

8.66. Among possible barriers to entry, particularly by ex-building societies, were brand and reputa-tional factors. The requirements of a personal consumer market were also drawing the ex-buildingsocieties to high street sites not accessible by car and a particular mode of presentation to personalconsumers which was going further away from the facilities required by many small businesses. Theywere recruiting managerial and counter staff who were not equipped and could not easily be trained tohandle the small business market. Such organizations might be interested in lending were there not alsothe systematic cross-subsidy due to the capacity of the four main banks in England and Wales and thetwo in Scotland to overprice money transmission systems and to allocate a proportion of that surplus tocreating an artificial and competitive barrier to entry in the provision of term debt. Moreover, because itwas a local market the competitive response of the established players in local markets might cost solittle as to make it uneconomic for potential entrants to enter any particular market.

8.67. A further entry problem was bundling on the demand side, ie customers using money trans-mission services thought they might need a loan at some future date, even if they did not need a loanthen, hence they ought to take their money transmission services from an institution that was likely in thefuture to give a loan. This made it difficult for institutions that provided only money transmission ser-vices to enter the market. On the other hand, given the way in which the prices were structured, it wasalso difficult for an institution that only wanted to offer loans to enter the market. The same was also trueon the deposit side with the added complication of how quickly money could be moved from a depositaccount to a current account in the event that the current account started to run out of money. If it werethe same institution, transfers could be done on the same day; but between different institutions, unlessthe customer was prepared to pay about £20 per transaction, it would take at least three days: a furtherbundling. Mono-line producers therefore found it difficult, either because of demand-side factors, orbecause the one thing they might provide on its own was underpriced.

8.68. It was in part because of the real economic barriers to entry to supplying services to SMEs thatfurther intervention was required to give small businesses the same benefits expected to arise from newcompetition in personal banking.

8.69. As to the scope for new technology to increase competition, the money transmission servicesthat could be conducted electronically were limited: cheques and cash, as the most significant methods ofmoney transmission for the foreseeable future, still required physical access. Telephone and Internetbanking were a means to ascertain balances and switch money between current and deposit accounts, butto run a deposit account at another institution required three days in the clearing cycle with problems forcash flow. Whether use of new technology would actually lead to the development of more effectivecompetition within the market was therefore open to question. Without effective competition, the Internetand related technologies made it easier to exploit market power: there was not an automatic associationbetween the deployment of new technology and more competitive markets.

8.70. It was similarly uncertain how lending decisions would be made over the Internet, whichneeded credit analysis of a firm’s business, but without local knowledge the amount of information thatwas available was negligible.

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Possible remedies

8.71. Lying behind the BRT’s view of possible remedies was the economic analysis that it waspossible to be a profitable business bank on quite a small scale in a local or regional market. Withrelatively few branches in a city, with the capacity to outsource a back office to large-scale processorsand get non-discriminatory prices from them, it would be possible to build quite quickly and economi-cally, in terms of return on capital for equity investors, a business in which there was no economicimperative to expand elsewhere unless such an entrant wished to do so. That being the case, divestmentof a viable local business to a third party was economically sensible or possible. Such structural remedieswould not involve the physical dismemberment of buildings or teams of staff. That was a product of themore professional way the four largest groups had begun to run their small business banking over the lastfour or five years. They had made it possible for a structural solution to work at some, but not huge,inconvenience to the customers. US experience where businesses were divested showed that some cus-tomers quite liked the newcomer, and some of those who were being forcibly moved to the newcomerdid not like that and moved on. This would be highly inconvenient for a few, but not necessarily incon-venient for the many. This was, crucially, not the structural dismemberment of a vertically integratedorganization, because it had the underlying payment systems that could serve any combination. Suchdivestment would therefore be of a viable business unit (including relationship managers) which encom-passed keeping in place local knowledge and relationships. These seemed rather dramatic measures, butthe argument was that competition was so poor that some structural solutions were required, andevidence from the USA indicated that this was not nearly as difficult as would be argued and was at leasta credible threat. In certain markets it might indeed be sufficient for the banks to sell branches to eachother; in others it would not.

8.72. A further approach was an obligation on a bank with significant market power in a localmarket to provide money transmission on non-discriminatory terms to the customer of a new entrant. Ifthat new entrant could satisfy the small firm’s need for proximity to money transmission, it could offerbetter borrowing terms or other services, before establishing branches in the area: indeed in the USA,sometimes new entrants did not even bother to establish branches.

Other banks

Airdrie Savings Bank

8.73. Airdrie Savings Bank said that it was the last independent savings bank in the UK. Its tra-ditional business was providing a banking service to personal customers, but during the last ten years ithad progressively developed services for some 200 small businesses, including current and depositaccounts, overdrafts, term loans, cash handling and access to foreign/electronic payments through itsBoS connections. It operated only through its eight branches. Its small size and limited geographicalcoverage meant that while it could provide a personal and dedicated service within its territory itscapacity for growth was limited, but more by its own constraints than by market issues. It had been ableto develop by offering a different type of service to that offered by the major clearing banks in its area.

Bank of Cyprus (London) Ltd

8.74. Bank of Cyprus (London) Ltd (Bank of Cyprus) had prime banker relationships with some3,000 SMEs throughout the UK, primarily owned and managed by Britons of Cypriot or Greek extrac-tion. It regarded the UK SME market as overbanked and therefore intensely competitive. Any expansionout of its natural niche market could, although desirable, prove to be extremely difficult to secure profit-ably.

8.75. Bank of Cyprus said that one of the main difficulties in addressing a UK-wide SME portfoliooutside its niche market would be that SMEs were cash hungry and that a UK-wide branch network wastherefore a prerequisite. The UK clearing banks, uniquely perhaps in Europe, provided access to theirnetwork to competitor institutions on a commercial basis. Despite this, however, a major nationwidedrive for business relying on such collaboration would introduce a further dimension of risk to such aventure. This was because it would entail reliance upon a competitor’s network, both of tills and ATMs,and would mean that a large part of its transaction cost base was in effect in the hands of such

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competitors. Naturally, prospective customers would expect to be charged a competitive fee for countertransactions, ATM transactions and money transmission charges, and Bank of Cyprus would, as at pres-ent, have to absorb the relevant agency fees. However, that was not to say that the large banks were inany way culpable. They had invested vast amounts of money to establish these networks and it was opento any competitor to replicate them. Bank of Cyprus said that it was unreasonable to expect the clearingbanks to go very much further than they were in granting access to smaller institutions. It experienced nodifficult in securing bids for its clearing account.

8.76. An alternative, which might be of universal benefit, would be for charges for the use of theclearing system per se, as opposed to charges for the use of an individual institution’s counter network, tobe subject to standard transaction costs irrespective of user.

Crédit Lyonnais (UK)

8.77. Crédit Lyonnais (UK) told us that it provided some banking services to SMEs in the UK. Itspayment services were extremely modest, clearing being processed by a UK bank on its behalf. It did notgenerally provide lending to SMEs as a service in itself, its small lending book generally supportingother services that it provided in the UK or its international network. A modest amount of Treasuryservices were also provided to UK SMEs. On equity brokerage, corporate finance and mergers andacquisitions, it had a team dedicated to the small capitalization market, a subsidiary company of CréditLyonnais being a broker to between 30 and 40 small-capitalization companies. Among others, corporatefinance advice was provided to these clients. The SME team was part of a pan-European unit reporting toHead Office in Paris, a limited amount of their activity involving UK SME. Crédit Lyonnais told us thatduring the late 1980s and early 1990s it had opened nine provisional branches aimed primarily at themid-capitalization corporate sector; return from these branches was judged to be insufficient and theywere closed during the mid-1990s.

Halifax plc

8.78. Halifax told us that it had not to date had any involvement with the SME sector. However, itenvisaged that its new significant Internet banking operation, Intelligent Finance, would wish to providebanking services to the small business sector, and it was also considering how it might more widely enterthe SME market.

8.79. On the Cruickshank report, Halifax concurred with many of the recommendations made,although it was not convinced that some of the matters identified in the report were against the interest ofconsumers. In particular, Halifax believed that the current payment infrastructure was open and effective,and that there was enormous competition in the marketplace, with the ability for new entrants to come inand relatively low barriers to entry. Halifax did not therefore fully understand how a separate paymentinfrastructure would achieve anything that the current infrastructure was incapable of doing.

8.80. On money transmission services, Halifax was a member of APACS and BACS and two specialinterest groups, but not of CCCC. It joined APACS and BACS in the mid-1980s, following the deregula-tion of the building societies, since as a big user of BACS it was in its interest to join and get a directservice. It had looked at the cost of joining CCCC and providing its own cheque-and credit-clearingfacilities, but originally chose to clear through Barclays. It had reconsidered that decision a number oftimes but never concluded that there would be any significant advantage from disturbing the currentarrangement. It had also put the agency arrangement to tender (out-clearing and in-clearing beingtendered separately). Membership would give a ‘voice at the table’ and Halifax stayed close to thedebates on truncation and all the changes in cheque clearing; if it felt things were happening that wereagainst its interest, that would increase its desire to be a member: but so far it had not found that to be inits interests, principally for financial reasons. The joining fee would previously have been about£800,000, since any new member required significant processing changes from existing members, andHalifax would have to have taken on the sort codes it currently had through an arrangement withBarclays (although it would not have expected to have to change that sort code). There would also beother significant changes to make to its own processing and costs, possibly in the order of £5 million to£10 million, although it was likely that third party processors would be used for part of the processingcycle at least. Such investment in infrastructure was undesirable given the decline in cheque usage andthe overcapacity in the market.

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8.81. Using an agency arrangement had no effect on service levels, including the time cycles forclearing a cheque, Halifax’s time requirements being absolute and part of the tender. To change the basic2.5-day cycle of clearing into a 24-hour cycle, without increasing the level of risk, would require a totallydifferent infrastructure. On possible acceleration of clearing times, in particular the time to clear for fate(when a customer can withdraw the money credited to the account), Halifax noted that it would be poss-ible to build a communication system that transmitted details of failed cheques on day 3 (currently apostal system was used which usually provided such details on day 4), but only at considerable cost.

8.82. Halifax noted that one possible restriction was that, because it was not a member of CCCC, ithad to settle through a member with a BoE settlement account. This was not a problem if a member bothprocessed and settled on an ongoing basis: but processing through a non-member would require aseparate arrangement to settle. In practice, however, this was unlikely to prove a problem since banksthat used third party processors were keen to recruit more volume to their processor, so themselveswould be willing to provide settlement facilities.

8.83. On its attitude towards the SME market, Halifax told us that it had got involved in an aspect ofSME business in the mid-1980s when the then Building Societies Act allowed lending to housing asso-ciations and builders, such loans still being secured. The scope for such lending increased further under1986 legislation. The subsequent downturn after 1989 showed that Halifax lacked a branch infrastructurecontaining people who were experts in the risk diagnosis of business. Lending to SMEs would require ashift in focus from looking at asset value to factors such as ability to repay, including credit scoring: adifferent skill base for evaluating risk, particularly for unsecured lending or lending against equity, andwith a further requirement to monitor accounts. After that earlier experience, development of anapproach to small businesses, given that Halifax did not have the core competency, was not a priority.Currently, however, Halifax was of the view that increasingly there were ways to serve parts of thatsector better than it was served at the moment, for example using new technology, or by focusing onSMEs with deposit rather than lending requirements, although it had not precluded a lending role. As ofMarch 2001, however, Halifax had not recruited all the senior staff required to manage its expansion intothe SME market, nor finalized the proposition it would offer.

8.84. On barriers to entry, Halifax did not believe that lending to SMEs required a business’s currentaccount, since it was possible to examine bank statements, although there was a natural relationshipbetween overdraft facilities and current accounts. Deposits, however, were a free-standing area of busi-ness, and likely to become increasingly competitive. There was also not much to stop Halifax providingcurrent accounts. In some cases banks charged little for transmission services, but paid little on depositaccounts to compensate. This created an opportunity to compete for deposit accounts, which Halifaxintended to do: the limited entry into the market to date partly reflected the desire of businesses tomaintain existing banking relationships and improve the likelihood of flexibility in that relationship ifflexibility proved necessary. Most businesses also expected a single bank to provide a full range of ser-vices. The greatest barrier was on lending where particular skills were necessary, and would have to beacquired from within the established banking community, as would also be necessary to satisfy the FSA.While there might be scope to focus on particular sectors of business, Halifax saw little advantage intrying to enter on a local basis; unlike the US market, the UK had national payments systems. It saw noregulatory barriers to entry.

8.85. Halifax did not believe that its existing branch network put it in a position readily to enter theSME market. First, Halifax’s branch network was used primarily for personal savers and depositorsrather than current account activity and, with increasing use of the telephone, Internet and ATMs, theoffice network was likely to get smaller. Only the smallest businesses, in its view, would deliver cash tobank branches, larger businesses using carriers. But secondly, its local branches would not be to theadvantage of any loan business, for which an area-type arrangement would be more useful. Branch net-works were not therefore necessary for business banking, except possibly for very small businessesrequiring nearby cash deposit facilities.

8.86. Halifax was aware that a very small proportion of its customers used their personal accountsfor business purposes, although it was a condition of its current accounts that they were not used forbusiness purposes. Business accounts required more scrutiny under money-laundering regulations: henceHalifax had identified some accounts as being used for business purposes (only about 0.25 per cent of allits accounts) and asked for the use of the accounts to be changed (although in some cases the accountwas allowed to be maintained, subject to a higher level of scrutiny).

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8.87. Halifax had recently announced a new Internet-banking subsidiary, Intelligent Finance, with afull range of products for personal customers, but likely to offer deposit and lending facilities for SMEs.

8.88. Halifax believed that a main issue for the small business sector was that the level of support forsmall businesses was better in other countries than in the UK.

C Hoare & Co

8.89. C Hoare & Co told us that it did not market its services specifically to SMEs. It saw lending toSMEs on a portfolio basis, as practised by the larger banks, as risky, intermittently profitable and subjectto state intervention which tended to deter institutions (especially overseas ones) and to reduce compe-tition. Increased regulation following the Cruickshank report would make the SME sector less attractiveand reduce competition: C Hoare & Co would support none of the hypothetical remedies suggested to us.

Lazard Bank Limited

8.90. Lazard Bank Limited told us that it did not provide banking services to SMEs, or participate inany of the banking markets in the UK—money transmission, retail services, SME finance—which theCruickshank report found to be of concern. As a small organization, its resources needed to be concen-trated on products where it had some competitive advantage: merger and acquisitions, asset managementand specialized wholesale money market activities. It did not enjoy the necessary economies of scale(whether in capital or in transaction processing capacity) to make it possible for it to enter the marketsreferred to us.

Northern Rock plc

8.91. Northern Rock plc told us that it offered a business savings account that might be used bySMEs and also provided loans secured on commercial premises to SMEs, although regarded its scale ofoperation as very small. It had considered the SME market but decided not to extend its involvement thatfar since it preferred to continue to grow its core business areas, with very low unit costs. It was possiblethat as it developed its web banking, it might offer some services to SMEs, but that was not part of itscurrent plan.

Robert Fleming & Co Limited

8.92. Fleming provided retail banking services to individuals and to SMEs through Fleming PremierBanking. Its banking business was a telephone banking operation that had expanded consistently overrecent years through organic growth. It was focused on professional private individuals, and, in theirbusiness capacity, smaller businesses: about one-half of its clients were SMEs. Free banking was offeredup to a particular level of transaction, and interest paid on credit balances: it concentrated, however, ondeposit gathering, with no lending to the small business market. The funds were in turn channelledthrough Fleming’s treasury money market trading area, receiving a market rate close to LIBOR. SinceFleming did not have a branch network, those of its small business clients with significant cash require-ments tended to have a regular cash account with a local bank or building society. Fleming provided ameans to earn a decent rate of interest on surplus cash, and to write cheques on those accounts.

8.93. Fleming told us that it had not felt constrained at all in pursuing the strategic development ofthese activities. RBSG currently provided clearing services to Fleming: this was a straightforwardcommercial arrangement, and if it were necessary to switch to another supplier, it would be relativelystraightforward to do so (although it would be necessary to rewrite some of Fleming’s software codes,which were designed to interface with RBSG). There was no disadvantage to its customers from use ofan agency for clearing, nor did it see any disadvantages from being an associate, rather than full member,of APACS.

8.94. Fleming agreed with the statement in the Cruickshank report that a handful of banks controlledthe wholesale networks for money transmission services. Fleming did not currently regard this as a

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problem, but it depended on the behaviour of the banks controlling the system. Hence, the situation couldeasily change, and Fleming supported the view of the Cruickshank report that there was not enoughcompetition in that market, with very few providers and no sign of new entry, and with the proposal toestablish a regulator for the payments system.

8.95. Fleming’s lending activities were confined to commercial banking, a different part of themarket to SMEs. Fleming’s customers tended not to be in capital-intensive industries, and they hadlimited borrowing requirements. It believed that, if clients did want a loan (particularly if they requiredan overdraft), they would go to another bank, which would insist on their current account business alsobeing moved to that bank: few small businesses left Fleming, however, of which only a small proportiondid so for that reason. It also believed other banks required bulk deposit and current accounts to be heldwith them, in order, in part, that offset arrangements could be provided. Clients not requiring an over-draft, however, would be in a better position to acquire a single product from an alternative source, suchas a building society.

8.96. Fleming had not previously wished to develop a broader type of offering for SMEs, sincelending to small businesses could be problematic, particularly during a recession, and it was questionablehow profitable such business would be over a full cycle: but this strategy could be reconsidered follow-ing its recent acquisition by Chase Manhattan. Lending to SMEs would also require expertise, includinglocal knowledge and local sale forces, which Fleming did not currently have.

8.97. Fleming attracted customers primarily because they were dissatisfied with the level of chargesfrom their previous bank, lack of interest on current accounts, and poor services. It believed it could pro-vide better quality of service at its current relatively limited scale of operations: a significant expansionwould require a significant upgrade of IT facilities, call centre staff etc. However, lack of knowledge orinformation, or apathy or a feeling of being tied to their existing suppliers, inhibited many categories ofcustomers from switching their accounts, as did the possibility that customers might wish to borrow fromtheir bank.

8.98. Fleming did not see significant regulatory barriers to entry into the market, subject to having abanking licence and (unless using an agency arrangement with another bank) satisfying minimum capitalrequirements of 5 million euro. The FLA/BoE also required people to have the relevant experience aspart of a management term.

8.99. Fleming said that its main challenge was to increase awareness of its bank and its propositionwith limited resources, against full awareness of the main providers, reinforced by considerable market-ing spend. There was general apathy and inertia among SMEs, derived from a belief that all banks werethe same: hence Fleming targeted resources at areas known to be receptive. The requirement or perceivedrequirement to place money transmission and deposit business with the bank from which they procureddebt finance limited its ability to win such business.

8.100. Fleming agreed with the conclusions of the Cruickshank report. On possible remedies, it sawlittle need for disposal of branches, given the reducing need for a branch network, as long as banks con-tinued to allow clients of banks such as Fleming access to their branch networks: in such an event, inter-vention to secure access to money transmission on a non-discriminatory basis would be necessary. Inertiawas the key problem in the market. On the possible difficulty for consumers of switching accounts,Fleming saw no practical difficulty in a requirement for banks to transfer all information (such as stand-ing orders) on accounts of customers switching to new banks. It was already a requirement undermembership of BACS for personal business, and on which there was also a BACS pilot scheme forSMEs. As to whether banks were inhibited from accepting customers switching from other banks,Flemings did not see lack of information on existing accounts of customers as a significant difficulty:such information could be provided by the customer from its previous bank statements, etc.

Standard Life Bank

8.101. Standard Life Bank told us that it did supply some services to SMEs, namely a savingsvehicle to SMEs that provided very competitive rates on instant access and ten-day notice accounts. Ithad not considered providing additional services to SMEs, as its strategy was to build substantialpersonal mortgage book funded by savings and wholesale funds. However, it believed it could add valuein certain niche markets that fitted within that overall strategy, as with the services currently provided.

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Sun Bank PLC

8.102. Sun Bank PLC told us that it was a small niche player in the SME market offering financesecured on property or operating assets and business deposits. It did not operate a branch network, themajority of business being introduced by professional intermediaries. It believed that the barriers forentry for a new bank in the SME field were high, namely: the requirement for staff with specialist lend-ing knowledge; the need for access to capital to support lending; the dominance of the clearing banks inworking capital activities such as money transmission, overdraft facilities, and intense pricing compe-tition for deposits. It did not believe that satisfactory returns on capital could be achieved by offeringhigh-activity-based services that were the domain of the clearing banks, and did not aspire to compete inthis arena. High levels of regulation were also likely to increase costs at providing services to SMEs.

Tesco Personal Finance Limited

8.103. Tesco Personal Finance Limited told us that it was a 50:50 joint venture between Tesco plcand RBSG. It had developed a range of products geared towards the personal market. It had not under-taken any detailed analysis of the SME banking market in the UK and had no immediate plans to do so,its core target customer base being Tesco shoppers. The SME market had different needs and requireddifferent skills and techniques that it did not currently possess.

Triodos Bank NV

8.104. Triodos told us that it was an ethical bank specializing in social and environmental invest-ment. It entered the UK market in 1995, when it took over a small UK bank. It had one branch in Bristolbut no branch network in the UK. It provided full banking services to SMEs including current accounts,overdrafts, term loans and project finance through post, telephone and fax. Its account-holders hadcheque books and paying-in books, but they had to make use of branches of clearing banks to deposit oraccess cash.

8.105. Triodos had a team of eight staff with the expertise necessary to make the lending decisions.It tried to find people who had both professional skills and their own environmental interest orsocial/environmental interest. It had an almost traditional banking approach rather than reliance on creditscoring. It believed its failure rates were much lower because it was closer to its clients in the first place,and structured its loans around what it expected the cash flow to be.

8.106. Triodos rarely provided unsecured lending, although the security that it took was sometimesunusual because of the nature of its business with, for example, guarantee communities, although it didoffer unsecured overdrafts as well. Triodos believed that many of the clearing banks offered bankingservices as a loss leader to sell other products, whereas Triodos did not sell insurance or pensions orother much more profitable services. It did very little cross-selling because it did not have a range ofproducts to do so.

8.107. In order to be able to establish its operations here, Triodos had to go through a process ofnotification with its own base regulator, the Dutch Central Bank. It now had to have discussions with theFSA, and the FSA had a responsibility for monitoring its UK liquidity, but apart from that it made purelystatistical returns to the FSA. Because it had taken over an existing bank in the UK, it also had to discusswith the BoE what the nature of the takeover would be, and various other processes it had to carry out.Once it had convinced the Dutch Central Bank that it had an adequate business plan etc, then there wereno further steps it had to take with the BoE, although the BoE had considerable discussions with theDutch Central Bank. The process took about two years, partly because the protocol between the BoE andthe Dutch Central Bank was still being talked through, and probably cost about £150,000.

8.108. As to whether the process would have been more difficult, perhaps even more lengthy, if itwere trying to set up branches anew, Triodos’ impression was that it would not be that difficult as long asit could convince the home-based regulator, the Dutch regulator, that it had enough management capa-city, enough resources, etc. It was looking at setting up an office in Ireland and expected that it wouldtake about six months or so to go through all of the formalities.

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8.109. Prior to the implementation of the EC Banking Directive, it would have been technicallyimpossible under British banking regulation to open a branch, but it could have established a subsidiaryin the UK that would have been UK-regulated. The Banking Directive had therefore made it easier toopen a branch in another EC country.

8.110. Triodos said that there were three areas where the current systems could be opened up toincrease competition. First, the present clearing system, owned by the major clearing banks, was a closedsystem. Triodos could not have direct access to this system, but had to enter into a contract with one ofthe major clearing banks to do its clearing for them. This was much more difficult and expensive than inthe Netherlands where Triodos was directly linked to Interpay, the national clearing system that wasopen to all banks, regardless of their size.

8.111. Triodos was not big enough to be a member of BACS or APACS; it would not make asignificant difference to be only an associate member of APACS. Following the takeover, Triodos got anumber of banks to tender for its payment arrangements. It went to five different banks, RBSG beingchosen: partly because the Scottish banks had a more neutral reputation on ethical issues, and partlybecause of the cost and service offered. Once a year it reviewed the charging level and put on pressure toreduce the charges and charges had gone down.

8.112. It would now be difficult to go somewhere else, since a change would necessitate a new sortcode. That would be highly complex, because all its customers who had standing orders and automatedpayment instructions such as direct debits set up had a coding which went through an RBSG sort code: ifit went to another bank all its customers would have to have the sort code of the new wholesale bank. Itwould be hugely time consuming and expensive to do that and almost impossible. Some servicescurrently obtained from RBS (for example, foreign currency transmission) could, however, be switched,which gave some leverage in negotiation.

8.113. Triodos said that there was quite a different system in the Netherlands where, even thoughTriodos was not a clearing bank, it got its own code rather than have to use a clearing bank’s code.

8.114. Triodos said that there was no necessary or technologically-driven reason for Triodos to havea sort code in the name of its clearing bank, nor any regulatory requirement; this was simply how theclearing arrangements were set up. A bank in the Netherlands, in contrast, had direct access to theInterpay system and its own codes, any new bank having the right of access to Interpay, providing itcould fulfil certain conditions including satisfying Interpay that it would be good for the credit risk andpayment of an entrance fee, which partly reflected the cost of building the system. Costs in theNetherlands were about [✄] per cent of those in the UK and actual clearing was quicker (althoughcheques were very rare in the Netherlands). [

Details omitted. See note on page iv.]

8.115. Secondly, Triodos said that opening up the Post Office network to bank account-holders fordepositing cash and possibly also accessing cash from their bank accounts could make it much easier forSME customers to run their accounts with Triodos. Triodos had to make arrangements locally for itscustomers to deposit or draw out cash. Banks did not generally make charges but more were now charg-ing. Triodos generally tried to see if there was a way it could use RBSG; if, as often happened, that wasnot the case it tried through RBSG to see if it could make arrangements with another local bank (how-ever, this pre-dated RBS’s acquisition of NatWest). In some cases it had made arrangements with localpost offices. However, until recently the Post Office had not shown much interest in providing theseservices.

8.116. Thirdly, Triodos wanted to provide its customers with Triodos ‘plastic cards’ (credit, debit orSwitch cards) to access cash through ATMs or pay purchases. However, the costs involved with becom-ing part of the required networks to enable customers to use these services had prevented it from do-ing so.

8.117. As to other possible barriers to competition, the problem with switching of accounts fromother banks depended on how extensive the account was. It was a simple matter to switch a savingsaccount, but the problems really arose with current accounts, because people had a number of

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arrangements set up around the current account. Most banks provided the customer with a printout of allthe arrangements, such as standing orders and direct debits, which Triodos took and carried out most ofthe work for the customer. The customer had to give authorization to do that but then Triodos contactedthe other party of the direct debit, for example, and made the required changes. Inevitably there was ahigh error rate involved that needed to be resolved.

8.118. If there were term loans with a bank, there were very often penalties to move to another bank.If borrowings were also being taken over to Triodos and it needed to take security, then there was thecost of taking the security, for example reregistering charges and solicitors’ fees, which could be quiteexpensive (in one case £10,000). Because of these difficulties, Triodos had a preponderance of start-upsin its new customers.

8.119. Triodos generally preferred its customers not to use other banks as well as itself, not forcommercial reasons but partly because the risk changed if there was a second bank. For example, if itwas lending to a customer and the customer also had a loan from another bank and got into difficulty,Triodos had to guess what the customer was going to do and also what the other bank was going to do. Itwas much easier, and the risk was much lower, where there was just a discussion between Triodos andthe customer. Where there were two banks involved, it was also more difficult to know what the cus-tomer was up to: if Triodos was reluctant to provide a loan because it thought it was getting too risky orthe customer was becoming overstretched, the customer could do it with another bank, but when it cameto grief, this would cause Triodos significant problems.

8.120. An ability for customers to take their account numbers with them would revolutionize themarket and allow customers to change banks very easily. Procedures around money laundering also actedas a strong incentive to stay with a bank because a customer did not have to go through procedures suchas providing four forms of identity, which could be a long process. Measures to assist switching wouldbe a better solution than regulation.

Whiteaway Laidlaw Bank Limited

8.121. Whiteaway Laidlaw Bank Limited (Whiteaway) told us that it offered a range of services topersonal and SME sectors. These services were supported by an agency agreement it had with RBSG.Customers had access to ATMs operated by RBSG and Barclays and fees for usage were met by thebank.

8.122. Whiteaway’s early activities had centred almost exclusively on supporting the operational andtreasury requirements of its parent, Great Universal Stores PLC. In the last two to three years it had pro-vided services to the SME sector centred mainly in the Greater Manchester area. In its three-year strate-gic plan to the FSA it had included a desire to expand its services to the SME sector and make efforts toexpand its geographic coverage of these facilities. The speed of its activities into the SME sector hadbeen dictated by the need to:

(a) build the loan book across a relatively broad range of economic sectors;

(b) ensure that it had the correct balance of underwriting and operational support skills;

(c) develop the correct range of savings products to allow further expansion to be funded from retailsources; and

(d) measure accurately the profitability of the business taking into consideration the levels of baddebt experience as the loan book gathered greater maturity.

Whiteaway’s initial views were that the SME sector was meeting its financial objectives and its appetitefor further ongoing controlled expansion remained strong.

8.123. Whiteaway told the CC that it was concerned about future proposed increases in the Switchpayment guarantee charge. Such increases would give a very significant increase in costs to its parentcompany as well as affecting the hundreds of thousands of SME businesses that relied on this method ofpayment.

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Woolwich plc

8.124. Woolwich (prior to its acquisition by Barclays) told us that after its conversion from buildingsociety in July 1997, its objective had remained to provide relevant personal financial services focusedon housing finance and retail savings products. It had continued to follow this course, with related ser-vices remaining close to its core aims. In some activities, such as lending on non-residential property, ithad provided services for businesses; in others quite explicitly it had not. Hence its current account wasintended purely for use by personal customers and the account conditions specifically excluded commer-cial use. It had not therefore set out to provide a current account banking service for businesses, althoughon occasions individuals might establish accounts in their own name and attempt to use them forcommercial purposes. Woolwich discouraged such use and, where appropriate, sought to enforce theaccount conditions, leading to closure as the ultimate sanction. Given its heritage, therefore, it had notdeveloped either the skills or infrastructure necessary to provide business services, particularly in busi-ness finance and transaction handling; to do so now would require resources to be diverted from its con-sumer business, which was not compatible with its overall strategic direction. For the future, extendingits services into business banking might be a viable option only if the expertise could be obtained quicklythrough either an acquisition or a joint venture: neither of these routes featured in its current plans.

Building societies

The Chesham Building Society

8.125. The Chesham Building Society told us that it provided a limited number of loans secured onproperty to SMEs. It was possible that it might increase the level of secure lending to this sector, but itwas not likely that it would provide other banking services such as money transmission, overdrafts orother unsecured credit. The main reasons for not doing so were that the regulatory framework had a biasagainst such lending and there was a perceived risk of significant losses on this activity.

Derbyshire Building Society

8.126. Derbyshire Building Society told us that the only banking service provided to the SME sectorwas that of taking deposits, which accounted for a very small proportion of its business. It was a regional,mutual building society with strong community support and loyalty, and its memorandum stated that itsprincipal purpose was that of making loans secured on residential property funded substantially by itsmembers. It was very customer focused and put its efforts and time into meeting its customers’ needs.Providing banking services to SMEs did not fit into this framework. Typically SMEs brought low-balance, high-transaction accounts, a type of business ideally suited to banks as they charged for servicesprovided on a commercial basis. It had considered the possible expansion of its SME business intocurrent account processing, but came to the conclusion that this was not a suitable activity for a mutualsociety to undertake to any significant level, the infrastructure and skill base required by SMEs not beingpart of its competencies.

Furness Building Society

8.127. Furness Building Society told us that it did not provide banking services to SMEs and had notconsidered doing so. It saw itself very much as a traditional building society and the set-up cost of pro-viding such services would be significant.

Kent Reliance Building Society

8.128. Kent Reliance Building Society told us that it generally did not provide banking services toSMEs. It did, however, probably by default end up as acting as a clearing facility for some small busi-nesses which tried to avoid bank charges by paying in cash and cheques through its offices and intodeposit accounts. These funds were then transferred out to their banks. It had considered providing

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banking services to the SME sector, but believed its strength lay in serving personal customers; it wasnot geared up to provide such services and because it would have to utilize the clearing services of abank, it was unlikely that it would be able to compete competitively.

The Mansfield Building Society

8.129. The Mansfield Building Society told us that the savings facility it offered did not extend tothe usual money transmission and banking services. It had considered provision of banking services fromtime to time, but determined that it should concentrate on its core business, that of raising funds to lendprimarily on first mortgage of residential property. It took the view that there was sufficient capacity inthe banking sector and that the large organizations and new entrants were better placed to provide thoseservices, including services to SMEs in the UK, bearing in mind their economies of scale.

Monmouthshire Building Society

8.130. Monmouthshire Building Society told us that it did provide deposit, secure loans and insur-ance services, but its size and system capabilities would make it very difficult to introduce banking ser-vices and it had not done so.

Newbury Building Society

8.131. Newbury Building Society told us that it provided only the simplest of indirect banking ser-vices to small businesses, the scale of which was negligible. It had not considered the further extensionof banking services because it believed that the risk, costs and reward were not commensurate with theobjectives of a local savings and loan institution.

Newcastle Building Society

8.132. Newcastle Building Society told us that it did not provide banking services to SMEs and didnot intend to do so. It had chosen not to operate in this segment of the market, as it believed that for anorganization of its size the risks/reward ratio did not justify the investment of resources.

Norwich and Peterborough Building Society

8.133. Norwich & Peterborough told us that it offered a range of money transmission, debt anddeposit services to SMEs. It said that it did not see any particular difficulties or obstacles to its provisionof services to SMEs resulting from money transmission arrangements, several banks being willing totender to provide such services for the society. The main obstacle it faced was that the high street banksheld the bulk of current accounts for deposits. Many businesses tended to see their bankers as their firstpoint of contact for banking services and mortgage monies. The account-holding bank had the advantageof the existing knowledge of the financial position of the applicant in those circumstances. In the main,Norwich & Peterborough overcame this obstacle by utilizing the services of introducers. On occasions,the society had found difficulties in advancing further monies to existing customers where a bank held asecond charge on the property being held as security. It would ask for the second charge to be postponedin favour of the further advance; if the bank refused it was unable to grant the additional monies. Some-times banks would also offer discounts on other services by packaging products together to retain busi-ness. Other lenders apart from the high street banks would experience the same obstacles; smallerinstitutions might also have a limited asset base and possibly limited funds, which would mean that theyhad strict criteria that many businesses would not be able to meet. The lack of a high street presence formany financial institutions might also result in potential clients not being aware of the alternativelenders.

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A building society

8.134. A building society told us that it did provide some banking services to SMEs but the scale ofits activities in this area was small. Generally it provided banking services where it had an existingrelationship with the enterprise by way of a mortgage loan, although in some instances it merely pro-vided banking services without mortgage connections. It had considered expanding the provision ofbanking services, but would continue to limit this to its geographic operating area rather than the wholeof the UK. The primary reason for not expanding provision of services within its operating area was aconcern that it would be difficult to make such an operation profitable. If the banking services to be pro-vided were to include overdraft facilities, then the probability of significant losses arising would be amajor deterrent to a significant expansion in the area. It believed that the economy was currently in areasonably favourable part of the business cycle, but there was a high propensity for the SMEs to gener-ate significant losses at times when the economy slowed down or was in recession. However, to set costsso as to cover future losses would lead only to complaints and poor publicity. A further concern was thatthe owners/managers of SMEs needed, by definition, to have a high level of belief in their organization,despite any current difficulties they might be experiencing. Typically a business experiencing problemswould have a view that those could be overcome provided their bankers not only continued to supporttheir present level of borrowing but also increased funding. While in some circumstances it might beappropriate to increase borrowing, very often a prudent lender would wish to restrict further loans.Different views between the owners/managers of SMEs and their bankers would also give rise to a highdegree of conflict and a great deal of costly management time on the part of the lender. The cost ofmanaging banking relationships with SMEs and the potential for conflict therefore made this anunattractive business proposition for many potential lenders.

Other financial organizations

Association for Payment Clearing Services

8.135. APACS, which was formed in 1985, told us that prior to its formation there was very littlecompetition in the agency market. Since that time, however, APACS believed that the agency market hadbecome much more competitive. However, this had reduced the attractiveness of settlement membershipof the APACS clearings, and even keener competition in the 1990s led to more than one institutiongiving up APACS membership. Several quite large banks also felt it was cost-effective to have an agencyin one clearing while having settlement membership of another APACS clearing. Such banks and otherinstitutions were understood to review their agency position on a regular basis.

8.136. Even relatively small settlement members of APACS clearings offered agency relationshipsto other institutions, thus increasing the potential level of competition in the agency market.

8.137. With regard to the difficulty in changing sort codes inhibiting the ability of banks to switchagency agreements, APACS was at present giving active consideration to the possibility of making sortcodes with the first two digits 70, which were at present used by UK offices of overseas banks, availableto other agency banks, which currently had a code from their clearing bank. APACS was aware that thiswould not offer an immediate solution, and would serve little purpose unless undertaken when a bankmove was made.

8.138. APACS believed that while it might be feasible for agency institutions to be provided withtheir own sort code, transferability of customer account numbers would be infinitely more difficult. Sucha practice, in APACS’ view, would be horrendously difficult to undertake.

8.139. APACS was not aware of any unsatisfied demand from banks or building societies to join itas settlement members and ascribed this to its belief that it was possible to provide a full range of bank-ing services without having to move to full settlement membership of one of the APACS clearings.

8.140. It had been suggested that the published minimum volume criteria for the APACS clearingserected a barrier to membership for smaller institutions. APACS told us that in practice these criteria hadnot proved to be a major barrier for the past decade; indeed, it had a member of CHAPS Euro who putthrough only a handful of payments each day. Rule changes to remove minimum volume criteria fromthe clearings had been agreed in principle and would be formally incorporated in the Rules at a GeneralMeeting in July 2001.

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8.141. APACS pointed out to the CC that the value and fate dates, given by banks to their businessand personal customers regarding clearing times, were not necessarily directly linked to the interbankclearing cycle. It was a matter of risk assessment within individual institutions.

8.142. The business of cheque processing was undergoing major structural change as the membersof CCCC were moving to outsource their cheque processing. Against this background of change, whichmight not be finalized until 2003, CCCC was examining the possible extension of electronic imaging ofcheques between banks, which was currently taking place within banks. APACS believed, however, thatwith volumes of cheques now demonstrating an increasingly rapid rate of decline, it might not be prac-ticable to shorten the underlying processing cycle, a point endorsed in the Cruickshank report (paragraph3.217). A more realistic objective for the short to medium term was for certainty of fate to be communi-cated electronically at a specified point. This could, if achieved, significantly improve the basis for therisk assessment of paper clearings by banks.

8.143. APACS was aware that, on occasions, there was a one-day delay in obtaining clearance forScottish cheques paid into English bank branches and measures to overcome this were currently beingconsidered by CCCC. Discussions had also taken place with the Northern Ireland clearing banks.

8.144. Most customers currently ‘got value’ by the close of day 3 (the second day after paying acheque into their account). On the same day there was settlement between the banks, but this was outwiththe cheque-clearing cycle per se and therefore entirely a competitive matter for the individual bank.Generally, however, customers could not draw on the value of cleared funds until day 4, and in the caseof some banks day 5, in case cheques ‘bounced’, such cheques still being returned by post. Until aboutfive years ago most major banks sat on the money for a day, earning ‘float income’; some of the smallerbanks possibly still did so, but probably none of the Big 4. Banks could currently derive income, how-ever briefly, from interest earned on money passing between customers’ accounts in the followingcircumstances:

(a) as a result of a competitive decision taken by the collecting bank in relation to its customerproposition as regards any delay in clearance for value (this could be either by direct clearing orclearing by an agent);

(b) standing orders (which were debited from customers’ accounts at the outset) going via BACSfrom one account to another (and were credited two or more days later);

(c) some bank giro credits between accounts;

(d) bankers’ drafts; and

(e) one-off payments initiated by telephone, e-banking etc.

Anglia Business Associates Ltd

8.145. A member of the Group conducting the inquiry visited ABA, one of the UK’s leading bankcharge auditors. In the last 12 months ABA had been successful in obtaining £2 million in refunds.Almost all of its customers were SMEs, mainly in the turnover range of £250,000 to £2 million. ABAwas currently performing 100 audits of customers’ bank statements and had a waiting list of over 200.ABA told us that it performed audits of bank statements of all the main clearers and its relationship withthe banks was generally good. Approximately 75 per cent of audits result in a refund.

8.146. Some examples of settlements obtained and files reviewed were:

(a) A NatWest customer had total interest and bank charges for the period August 1987 to February2000 aggregating £509,000. The audit resulted in a reduction in interest of £76,000 and othercharges of £56,000 (including compound interest where appropriate).

(b) A customer of Barclays had total charges for the period December 1986 to November 1998 of£130,000. The audit resulted in a refund of £12,500.

(c) A customer of Midland obtained a refund of £231,000 following a 26-year review of bank state-ments.

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8.147. Many claims were resolved quickly because they were simply undisputed clerical errors, butsome of the more interesting claims included the following:

(a) In Scotland, Scottish clearing is two working days and English (or non-Scottish) clearing inScotland is three working days. Mixed clearing (ie a combination of English and Scottishcheques) is three working days, thereby giving the Scottish bank a minimum of one day’s valueon Scottish cheques. One example was a customer of Clydesdale, in which ABA claimed£36,000 in lieu of interest forgone over a four-year period.

(b) In respect of returned cheques, good practice was to ‘refer to drawer’ after no more than onerepresentation. ABA said that it had examples of multiple representations. It also quoted anexample of the extra cost to a bank customer being debited on presentation and returning thecheque the following day under the ‘inadvertence rule’. In this way the customer was charged(i) one day’s interest probably at the bank’s penalty rate and (ii) either the debit entry cost of thecheque (if charged on a per item tariff) or a percentage of the cheque’s value (if on a debit—turnover % charging arrangement) as well as (iii) the bank’s unpaid item fee.

(c) Several banks charged excess interest rates for the period between agreeing a borrowing limit (ora higher borrowing limit) and the date of ‘marking’ the account with the new limit. In this waythe customer never saw the penal rate of interest as part of his or her overall charges.

(d) Many banks, including the Co-operative Bank, HSBC, Lloyds TSB and NatWest, used to oroccasionally based their charges for operating business accounts on debit turnover. This isexpressed as a percentage of turnover, but ABA pointed out that it was potentially flawedbecause it was based on previous year’s turnover and the current year’s charges might becomedistorted, for example by high-value cheques such as for capital expenditure. Banks must (butdid not always) review regularly and adjust.

(e) RBSG occasionally based its charges on credit turnover. (ABA had a current case involving adispute over a charge of approximately £3,500 for simply banking an insurance claim cheque of£1.6 million.)

(f) NatWest charged an aggregate of £35,000 for unpaid items over a period of 13 years (iecontinuing the relationship while permitting a customer to continue to write cheques, in this caseapproximately 1,300, which subsequently were dishonoured).

(g) AIB charged penal rates of interest on the whole of a loan to a residential care home (in England)for the periods between expiry and formal renewal of a facility over a period of 17 years (claimamounted to approximately £7,000).

(h) There were excessive charges for monitoring a loan. In one case Midland charged £500 a monthmonitoring fee for a £70,000 loan.

(i) Ulster Bank had a standard rate that implied its base rate. In fact, its standard rate was 2 per centover base rate.

(j) There were instances of Lloyds TSB’s insurance protection scheme where the cost of the schemewas charged in full up-front on draw-down of the loan and treated as part of the loan and no dis-count given for early repayment.

8.148. Among other matters raised by ABA were the following:

(a) It felt strongly that statements should show cleared balances to allow customers to reconcileinterest and other charges, especially when the statement showed that balances were alwayswithin limits or always in credit. It also believed that a charge for interest and charges should bein invoice format.

(b) While facility letters had improved, this was not necessarily so with attached terms and con-ditions. For example, NatWest stipulated 29.5 per cent interest plus £3.50 per calendar day forunauthorized transactions (Midland £2 per business day), whereas Barclays stated that if limitswere exceeded the customer might be subject to extra charges.

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(c) There were examples of the practice of setting borrowing limits below agreed and/or regularlyallowed borrowing levels, causing interest on balances above those limits to be charged atpenalty unauthorized borrowing rates.

(d) There was loss of value to the banking system for credit card transactions, ie debits could be twodays earlier than the corresponding credit (but ABA had not been able to prove this on a system-atic basis).

(e) As an additional complication of switching, banks were reluctant to deal with late presentation ofcheques once the switch had taken place, ie they would return cheques rather than liase with thenew bank.

(f) Grouping accounts for interest set-off purposes was not always as straightforward as it seemed.For example, if a customer had a credit balance of £10,000 and a debit balance of £25,000, thegrouping would be expected to produce an interest charge based on the net balance of £15,000.This was not necessarily so. An example quoted was an interest charge on £15,000 plus 2 percent (the ‘turn’) on £10,000. Although banks knew that credit balances used in interest set-offarrangements were often subject to a ‘turn’, ABA had examples where the customer was notinformed of this.

Bibby Group of Factors Limited

8.149. Bibby Group of Factors Limited (Bibby) told us that it provided debt factoring servicesthroughout England, Scotland and Wales. [ Details omitted. Seenote on page iv. ]

8.150. Bibby told us that since it was not a direct member of APACS it did not need to becomeinvolved in its administration. [

Details omitted. See note on page iv.

]

8.151. [

Details omitted. See note on page iv.

]

8.152. The debt factoring market had become increasingly competitive as new players had enteredand the threat of substitute products (primarily bank overdraft facilities) continued to increase. Themarket had also continued to grow, and in terms of volume during 2000, there was a substantial increaseof over 20 per cent. These conditions made it increasingly difficult for new entrants to enter to offerfactoring facilities. However, the most significant obstacle that existed was the ability to generate astream of introductions for new business. Subsidiaries/divisions of the banks had the benefit of a dedi-cated branch network. The independent factors/discounters had to rely on third parties for introductionsand therefore placed significant emphasis on building long-term relationships at an individual level.Without the benefits of these relationships or the branch network, a new entrant might struggle to suc-ceed within the market.

8.153. [

Details omitted. See note on page iv.

]

8.154. [

Details omitted. See note on page iv.

]

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Close Invoice Finance Limited

8.155. Close Invoice Finance Limited told us that all the UK banks used a security mechanism of anall-assets debenture over a company. The effect of this was that the bank encompassed within its chargeall the assets of the company to support its lending by way of overdraft. This restricted companies fromusing their assets to maximize borrowings, since they had to get permission from their bank to enableany assets to be released. In the case of factoring this meant that any factoring company wishing to lendmoney to a small business had to get a waiver to enable the debtors to be taken out of the bank’s charge.It often found that the bank delayed the granting of this waiver and attempted to force the small companyto use the bank’s own factoring or discounting company. The small business was not in a strong positionto negotiate when that occurred, or to move to another bank. In many cases, moreover, they attachedlittle or no value to that security for lending purposes: there should be a statutory right of disclosure as tothe extent to which the bank was reliant on the charge over debtors, so that if it was not required, thecustomer could arrange additional working capital.

8.156. Banks could not be allowed adversely to affect the cash-flow and trading decisions of a com-pany by such restrictive practices. At present they had the ability to threaten the removal of an overdraft.

8.157. Should a company seek additional funding of its unencumbered assets elsewhere, this totallycompromised the company directors and unreasonably influenced their decisions for managing theircompany.

Earthport plc

8.158. Earthport plc (Earthport) is a UK company focusing on the provision of a secure, seamless,fast and economic Internet payment system to banks, telecommunications companies, service providers,portals, merchants and their customers. Earthport believed that the cost and length of time associatedwith transferring cleared funds had meant that SMEs and their customers had been tempted to rely ondebit and credit cards for payment in electronic or distance transactions. Such cards were not readilyavailable to many consumers, and credit cards in particular had a limited global penetration comparedwith bank accounts and those offering to accept physical cash payments that were capable of beingautomated. High costs associated with credit and debit cards made them inefficient at handling low-valuepayments. Further, the high rates of fraud and other breaches of security in this context demonstrated thatthe procedures related to card payment security and fraud detection and prevention had not been ade-quately adapted to situations where the cardholder was not present.

8.159. Earthport believed that real progress towards an efficient money transmission system wouldbe achieved only when innovation and competition were aimed at the secure, seamless, fast and cost-effective transfer of even the smallest payments electronically between merchants (the vast majority ofwhich were SMEs) and their customers.

8.160. However, the current structure of the banks and the banking market made it very costly anddifficult for banks to agree the necessary standards and protocols to enable the requisite links to be estab-lished with their electronic customers in any reasonable time frame. Many individual banks were seekingto assemble their own proprietary systems in an effort to extend or better their market share of bankingservices in the e-commerce environment. This would not enhance the accessibility or interoperability ofthe central clearing mechanisms.

8.161. Earthport believed it was vital that new entrants were encouraged to commit the necessarycapital, expertise and other resources to assist in the rapid evolution of a more efficient centralizedclearing mechanism for the money transmission system.

8.162. Earthport felt that basic customer information that was exchanged between clearing bankscould be made available to other participants in the clearing process thus reducing cost and delay. Thecost and delay associated with transferring cleared funds should reduce reliance on debit and credit cardsfor payment in distance transactions. However, systems that facilitated the use of these cards should pro-vide user authentication and limit the instances of disclosure and storage of card details in addition toother compliance and security procedures applicable to online transactions generally.

8.163. Banking products and most key components of the money transmission remained nationallyfocused, despite sustained growth in international travel, the desire for a single European market and the

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availability of products for sale electronically on a worldwide basis. Debit and credit cards did not repre-sent a solution in this context, owing to limited penetration, high costs and security issues. Customerfrustration was being supplemented by growing pressure from the European Commission for banks tocease discriminating in their fee structure against small-value, cross-border payments. It was thereforevital that the central clearing systems accommodate cross-border, multi-currency transactions of any size.

8.164. A large number of banks requested account-opening deposits, but were frequently not willingto pay interest on these deposits to SME customers. This lessened the ability or likelihood that SMEswould open their own accounts at different banks to facilitate their own money transmission, therebyincreasing their reliance on the existing bank systems, and the high costs associated with interbank trans-fers made on their behalf.

8.165. New market entrants could experience day-to-day barriers to achieving settlements due tolack of information from banks, which other banks would not experience. For example, Earthport couldnot get direct access to SWIFT, as Earthport was not classified as a financial institution. This obligednew market entrants to approach established market participants, thereby perpetuating the existingstructure.

8.166. Earthport believed that access to the tools (for example, central clearing systems and author-ized access to existing account information) of low-value money transmission on fair, reasonable andnon-discriminatory terms would greatly enhance its access to the market. Real increases in efficiencywould only be achieved by ensuring that secure central electronic clearing mechanisms were seamlesslyinteroperable with the vast range of electronic systems being operated by financial institutions on the oneside, and merchants and portals on the other. While regulatory initiatives, such as PayCom and theElectronic Money Directive, might represent one route for introducing such competition in an orderlymanner, the introduction of ‘red tape’ may inhibit the competitive advantage of the new entrants, to thebenefit of the clearing banks.

Five Arrows Commercial Finance Limited

8.167. Five Arrows Commercial Finance Limited told us that its core business was providing dis-counting and factoring facilities. The most significant issue it had with the clearing banks was that it wascommon for its clients seeking additional services from their clearing bank to be offered them only oncondition of switching their discounting or factoring facilities to the clearers’ own subsidiary.

GMAC Commercial Credit Limited

8.168. GMAC Commercial Credit Limited (GMAC) told us that the obstacles it faced in growing itsservices to SMEs were, first, its dependence on the major banks to provide money transmission serviceson its behalf. When using its services, this could serve to disclose its client base details to the banks thatwere its prime competitors. Secondly, it was unable to provide funding directly to certain EuropeanSMEs as it was not a recognized bank or financier under their local laws. Finally, the banks held amonopoly on the provision of agency sort codes, as these were not made available to financial companiesother than banks. As a receiver of thousands of receipts daily from SMEs that affected its clients’(SMEs) funding and cost levels, this was a significant factor. In order to overcome this obstacle, signifi-cant amounts of additional administration were required by it and its clients via the setting up of varioustrust accounts that only ultimately served to provide even more income to the major banks.

8.169. Other factors that had prevented financial companies other than the major banks from pro-viding or growing existing banking services to SMEs included the lack of a distribution network.Secondly, the captive market was controlled by the four largest groups who, as a result of bundling theirservices and their income, were able to undercut other financiers. When other financiers sought refer-ences or security waivers, this served to provide an early warning system for the banks of the existenceof a competitive threat. By delaying actioning such requests, the banks could undercut and/or sell theirown service provision. Banking with the four largest groups was also regarded as important for themarket credibility of new SMEs. Finally, due to the large amounts of free capital and deposits, the majorbanks all had access to huge amounts of available cheap funding enabling them when required to under-cut the market.

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8.170. GMAC was itself unable to provide chequing account facilities or accept deposits due to itslack of a lending licence. This meant that it was always an additional financier unable to provide acomplete service. The funding it provided must always be deposited into a chequing current accountbefore the SME was able to distribute the money. This introduced additional money transfer costs.GMAC was disadvantaged in terms of pricing as it was unable to package any costs or income fromproviding money transfer facilities to offset its funding or administration costs, thus effectively making itappear less competitive.

8.171. GMAC particularly supported remedies that restricted the ability of the four largest groups tobundle services or provide financial inducements to encourage SMEs to use only in-house services. Italso agreed with the suggestion that the four largest groups would have to inform SMEs that there wereother providers of the banking services they were offering. It suggested: clearance time for cheques to beformalized, after which items could no longer be returned unpaid; improvement in the clearance time forinternational and currency cheques together with more effective tracing mechanisms; establishment andadherence to foreign currency transmission timescales; and withdrawal of the ability for major banks tocross-collateralize their facilities which would reduce their ability to impose conditions upon other finan-ciers for attempting to provide alternative or better facilities to SMEs.

The Post Office

8.172. The Post Office believed that SMEs should have access to competitive banking offerings andit gave us details about a number of existing arrangements for business account customers of clearingbanks at post offices, which currently are all operated via Girobank. It provided cash and chequedeposits, cash withdrawals and change-giving services for Girobank customers throughout the UK.Secondly, it provided deposit and change-giving facilities for Lloyds TSB SME customers at 11 branchesin Reading, a trial that had been running for one year. Thirdly, it provided deposit and withdrawalfacilities for Abbey National SME customers throughout the UK, although these were still on a trialbasis. Finally it had been providing services for the Co-operative Bank for over ten years, both depositand withdrawal facilities across the UK.

8.173. The corporate banking contract with Girobank contained an exclusivity clause that restrictedPOCL from unilaterally offering cash process services to business customers of any bank or buildingsociety other than Girobank. Both trials with Lloyds TSB and Abbey National had produced only lowvolumes and the current process used was not seen as helpful from either a customer or a banking pro-spective, for example the need to opt for the Post Office service and use Girobank stationery. It was dis-cussing with Girobank how to resolve these issues and expand the services offered to businesscustomers, but its room for manoeuvre was severely constrained by the contract with Girobank.

8.174. It saw business customers’ use of the network for banking services as a key driver in theachievement of its plans. A significant number of business customers already used post offices and theJanuary 2000 BBA report (Banking without Branches) indicated that 60 per cent of small businesseswould use banking facilities provided through the post offices.

RDM Factors Limited

8.175. RDM Factors Limited told us that sometimes it was placed at a great disadvantage as servicessuch as factoring were directly linked by the banks with the continued provision of clearing bankingfacilities.

Visa International Service Association

8.176. Visa International Service Association (Visa) commented on views expressed to the CC thatcredit card charges paid by merchants to their acquiring banks were higher than necessary, and that thesecharges included the cost of the ‘payment guarantee’ provided by the issuing bank, when merchants werenot always guaranteed the payment of fraudulent transactions. Visa believed this view was based on theerroneous assumption that the interchange fee was a fee for services supplied by the issuer to themerchant. In a four-party system, cardholders could use cards issued by one bank to pay for goods sold

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by a merchant signed up by a different bank. In a four-party system the system’s services were suppliedby issuers and acquirers jointly in the sense that it was the issuing and acquiring banks’ services com-bined that increased usage of the payment card—a consequence of the system’s ‘network effects’.

8.177. The system’s services were demanded by cardholders and merchants (the two groups ofbuyers or users of the system’s services) jointly and interdependently in the sense that cardholderdemand was dependent upon the number of merchants that participated in the system, and merchantdemand was dependent upon the number of cardholders who participated in the system. It followed thatmerchant demand would increase as more cardholders joined the system and cardholder demand wouldincrease as more merchants joined the system. These were the network effects referred to earlier.

8.178. The purpose of the interchange fee was to achieve the fullest possible satisfaction of the jointdemand of cardholders and merchants for the system’s services. In a four-party system the issuerincurred costs in recruiting cardholders and encouraging the use of the system’s cards, and its expen-diture and activities benefited merchants as well as cardholders. The same was true on the acquiring side.Without an interchange fee it was wholly improbable that the individual decisions of issuers andacquirers would lead to a combination of cardholder and merchant fees that would optimize the use ofthe system.

8.179. Visa believed that a mechanism was necessary to achieve the fullest possible use of a four-party system. The level of interchange fee influenced the decisions of issuers and acquirers as to, forinstance, the fees they charged and the amounts they spent on recruiting and serving cardholders andmerchants respectively.

8.180. Visa stressed that the fee was not mandatory and was a default fee. Banks were free to deter-mine on a bilateral or multilateral basis their own level of fee. Moreover Visa played no role in deter-mining a bank’s pricing policy towards its own customers (whether cardholders or merchants). It was upto the bank to determine, for example, how and to what extent it passed the interchange fee on to itsmerchant-customer.

8.181. Visa told us that these views provided only a brief summary of its position regarding the pur-pose of interchange fees and should not therefore be read as a complete or definitive explanation of thepurpose of interchange fees in a four-party system such as Visa’s.

Chambers of Commerce

Ashford (Kent) Chamber of Commerce, Industry & Enterprise

8.182. Ashford (Kent) Chamber of Commerce, Industry & Enterprise (Ashford CC) said that its cus-tomers were satisfied with the services and relationships with their banks. Generally it believed that eachbank was in a competitive situation in gaining or keeping customer accounts. Each bank offered a differ-ent business package to attract new business through its team of business advisers, and it was relativelyeasy for prospective customers to establish exactly what was on offer. Quite often, this decision was aftertaking advice from Ashford CC’s own advisers. However, Ashford CC was concerned that if there werefurther mergers or takeovers in the industry, this would be detrimental to business customers.

Bolton & Bury Chamber of Commerce

8.183. Bolton & Bury Chamber of Commerce (BBCC) said that there was currently a lack ofcompetition in UK banking services and the situation would worsen with the current trend of bankmergers. The present level of competition was forcing up prices, and increases in bank charges were notnegotiable. It believed that most banks were trying to provide too many services, often without thenecessary expertise, particularly at local level.

8.184. A majority of BBCC members saw bank charges as broadly consistent across the majorbanks, but levied in different ways. They believed charges had to be closely monitored and savings could

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be made by changing banks and through individual negotiations with bank managers. Some members,however, considered that charges varied among banks and SMEs were charged disproportionately highrates.

8.185. In the experience of most members, changing a business bank account was not easy, but nomore difficult than changing a personal account. Major difficulties experienced were the transfer ofstanding orders, direct debits and tax payments. On obtaining services from other banks, members weredivided. Some found it very difficult to obtain a service from a bank other than the one they regularlybanked with, while others had not experienced any lack of cooperation. One member had commentedthat other bank services could be obtained ‘at a price’, and that it was very costly to use a service from acompetitor bank. Members located close to the Bolton and Bury town centres felt the choice of bankswas reasonable, but out-of-town businesses had only two or three banks in their locality, and had totravel up to 11 miles for choice.

8.186. The majority of BBCC members believed provision of banking services via the Internet, sub-ject to adequate security controls being in place and assurances of reliability, would make a big differ-ence in the near future. Many, however, viewed Internet banking with suspicion, or felt it would taketime to have an effect on business accounts, since they still received large numbers of cash and chequepayments.

8.187. Among other specific comments about members’ experience of the banking business were thefollowing:

(a) Some banks would not set up Internet accounts, whereby a company could accept credit anddebit cards over the Internet, until a customer had a business account with them for at least12 months.

(b) A bank was always attempting to introduce its own services, particularly after receiving year-endaccounts, and which could be introduced under duress when a company was struggling for cashflow, when it might not be the best solution to solve the problem. Factoring was a particularexample of this.

(c) Banks did not realize the importance of trust in the relationship between the bank manager andthe customer, and having a bank manager that was accessible, friendly and genuinely interestedin the business.

(d) Banks had failed to improve services sufficiently, and tended to be more flexible and sometimestoo flexible in their judgement of new account business when the economy was strong whichresulted in drastic action when the economy was weakened.

(e) It had been impossible to obtain an account as a start-up business, requiring this particular com-pany to hold its business account with a seven- or even nine-day cheque-clearing time. It wastime the Government offered new banking licences.

(f) There was concern about the current trend in closure of local branches, meaning for many mem-bers a journey to the nearest town to deposit cheques etc.

British Chambers of Commerce

8.188. British Chambers of Commerce (BCC) represents more than 126,000 businesses of all sizesand sectors of the British economy. In its evidence to the Cruickshank review it expressed its belief thatthere was a lack of competition in certain aspects of SME banking provision, but that this was not true ofall product provision. There did appear to be strong competition in the provision of finance, with severalplayers in the market offering a range of products: for example, customers were making far more use ofalternative methods of finance than they once did with significant increase in the use of leasing inparticular.

8.189. In other areas of banking provision, BCC’s SME members expressed less satisfaction. Theyfelt the charges for some of their basic banking services were excessive. They also believed a monopolyposition existed in the provision of money transmission systems. The BCC supported the

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recommendation in the Cruickshank report to set up a payments system regulator, PayCom. BCC urgedcaution in interpreting the results of surveys that showed that customer satisfaction was improving, suchsurveys being influenced by cyclical factors.

8.190. BCC was concerned over the loss of smaller rural bank branches and the lack of choice ofbanks in many of the smaller towns and rural areas. Some banks could be in a monopoly situation insmall local towns and rural areas. However, locality was not usually reflected in pricing service pro-vision, with banks charging a standard price for most services across their branch network. The excep-tions to this were management fees and lending rates where there was usually some local discretion.BCC shared the concern that losing the last bank in an area, particularly a rural area, could lead to aspiral of decline as people went elsewhere to shop and use other facilities. However, it would be incon-sistent to expect banks to operate in a competitive market but subsidize loss-making branches. There maybe a need for intervention on the part of government as an object of sound and rural policy, rather than beexpected of the banks.

8.191. BCC was also becoming increasingly concerned that the concentration of banking services ina small number of banks was restricting choice in the small business sector. The deregulation of buildingsocieties in the 1980s and subsequent conversion of many former building societies into banks wasexpected to lead to increased competition, but that had not happened (or any entry had been confined to‘cherry picking’), the reasons for which were unclear.

8.192. In the personal banking sector the concentration of service provision could soon be diluted bythe increasing use of other mediums such as telephone and e-banking. BCC did not believe this wouldhave a big impact on large subsectors of the SME banking sector, such as retailers and other service pro-viders that were more reliant on use of a local branch. Having a large branch network helped existingplayers with many SMEs still reliant on having a branch close at hand to pay into and make withdrawals.Some former building societies had extensive branch networks, which suggested that this was not theroot of the problem. It was not realistic to suggest that competitors could use outlets such as fillingstations or electronic means given SMEs’ cash-handling requirements: for the vast majority of SMEsthere were no realistic competitors to the four main banks.

8.193. BCC said that the solution to encouraging greater competition in the SME market lay in theanswer to why other entrants had not entered the market. This might have related to particular legislationor rules, which could be easily remedied, or access to existing infrastructure. BCC wanted to seemeasures that worked towards greater competition in the market rather than the market being heavilyregulated.

8.194. BCC said that the problem was essentially a supply one, and there were some measures whichcould be taken to promote competition thorough more discerning consumers:

(a) changing banks could be easier—the administration involved in changing standing orders etc didnot promote switching; and

(b) information on charges—there had been increased transparency in banks’ charges in recent yearsand they were better at providing information, but there was further scope to improve the infor-mation on charges to their SME customers.

8.195. BCC did not believe there was a lack of competition in the specific provision of finance toSMEs. It was concerned by the conclusions of the Cruickshank report on this subject. BCC said therecommendation that the Government should progressively switch support from the Small Firms LoanGuarantee Scheme (SFLGS) towards an enlarged venture capital fund demonstrated lack of under-standing of small business finance. The SFLGS was an essential tool in the funding of British SMEs andwas often used in conjunction with venture capital finance to provide balanced and appropriate mix offinance. BCC research1 showed that the predominant reason that small businesses failed to obtain debtfinance was their inability to provide adequate collateral—the problem the SFLGS was designed toremedy.

1BCC Small Firms Survey—Finance. March 1999.

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8.196. BCC said that the UK had the largest capital market in the world as a percentage of its GDP.The problem was trying to encourage more of this to be invested in small businesses.

Hypothetical remedies

8.197. Commenting on the hypothetical remedies letter, BCC believed that the ultimate objectiveshould be to move towards a situation where the market for SME banking services was competitive. Onemeasure that it would therefore advocate was prohibiting the further concentration of supply. In the veryrecent past there had been some welcome developments, with the introduction of a few new entrants intothe SME banking market. Some of the former building societies, for example the Alliance & Leicesterand Abbey National, had sought to establish themselves. This process should be promoted, with newentrants protected from takeover by market incumbents.

8.198. It also supported the proposals to introduce behavioural remedies that would reduce orremove any barriers to market entry. For example, it would advocate introducing measures that made iteasier for small businesses to switch accounts. Such measures might include:

(a) minimum standards of service on changing accounts, which might include guaranteed timetablesfor transferring accounts and compensation, where standards are not met;

(b) in the transfer of loans, no penalties beyond those that recoup reasonable costs;

(c) portable account numbers; and

(d) requirements to share information, where a business wanted to switch from one bank to another,and which might be summarized in some kind of portable credit history.

Another potential remedy that might promote greater switching of accounts was the provision of morecomparative data and greater transparency in the charges that businesses incurred. This might mean pro-viding clearer, more detailed bank statements.

8.199. The area where it saw the monopoly situation causing most harm was in the provision ofbasic banking services to SMEs, the provision of a current account and cash and cheque-handlingfacilities. This affected some sectors far more than others, for example retailers, and was not somethingthat would ever be remedied by new methods of provision, such as the Internet. For many businesses,having access to a branch was a key aspect of their banking needs and in some areas there might be littlechoice, with only one bank servicing a neighbourhood. To remedy this, it would rather see measures toallow greater access to banks for non-account-holders than some of the other suggestions proposed bythe CC, such as promoting cash handling by other organizations (garages, supermarkets, etc), or the sug-gestion that some banks should divest some of their network.

8.200. It agreed with the CC’s comments on divestment, that such a structural remedy should beseen as a last resort, and the inconvenience it might cause customers militated against it as a desiredoption.

8.201. In its view, the primary objective of any remedies should be to move towards a situationwhere the SME banking market was competitive. However, that might take some time and in the interimSMEs might need some additional protection from the adverse effects of the current monopoly situation,if the CC deemed it to be against the public interest.

8.202. A start in that respect would be to require the banks to provide the DGFT with regular infor-mation on their profitability. Such action might in itself force down charges, although it might be diffi-cult to identify profits made purely from providing SME banking services. If that failed, the CC shouldconsider a system of price controls, which would be purely temporary until the market was restored to acompetitive position.

8.203. Beyond that, there were some charges, terms and conditions that were symptomatic of anuncompetitive market and which BCC believed needed to be addressed, although again in time, if themarket were to become competitive, some of these conditions might develop without the need to regulateor promote them:

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(a) a clearer contract between SMEs and their banks, particularly in overdraft situations;

(b) a move away from payment-on-demand terms for overdrafts, as one of the banks had recentlydone;

(c) a requirement to adopt the same set of money transmission charges for any given levels of activ-ity, which would hopefully allow many businesses with low levels of activity to be charged on apersonal tariff; and

(d) greater product differentiation: for example, as the CC suggested, SMEs would be offered achoice between tariffs, excluding the services of a relationship manager.

8.204. BCC was, however, concerned about the suggested windfall tax on the banks. It failed to seehow a tax, in itself, would benefit SMEs. All it would do was generate additional revenue for theGovernment, unless there was some mechanism for recycling it back to banks’ SME customers. It mightalso be difficult to distinguish the monopoly profits that banks generated from the SME market fromthose profits they made elsewhere in markets that were competitive. Damage could be done to thedomestic banking sector.

8.205. BCC did not support the proposals from some organizations that the funds generated by awindfall tax could be used to provide subsidized loans to small businesses. While undoubtedly thiswould be popular, it did not believe that the market for SME finance was uncompetitive. There were anumber of organizations that lent to SMEs including traditional lenders, factoring and leasing companies.In its view, the major problem of monopoly was in the provision of basic banking services, currentaccounts and associated services, and not the provision of finance. Subsidized lending to SMEs couldtherefore do more harm than good by damaging a competitive market.

8.206. There was also a question of whether a system of subsidized loans would get clearance fromthe European Commission under EC state aid rules.

Dorset Chamber of Commerce & Industry

8.207. Dorset Chamber of Commerce & Industry said that the four major banks represented anoligopoly in which competition for SME business existed only around a comfort zone. Competition wasrestricted by electronic systems, such as BACS which tended to lock in the provider: by loyalty or fear ofthe unknown; and by obscurity relating to charges, especially peripheral charges. As evidence of theimperfect market:

(a) prices offered to win new business were lower than long-term businesses; and

(b) there was a lack of initiative by the four major banks to replace contracting networks withalternatives such as mobile banking facilities for trading estates.

Dover & District Chamber of Commerce & Industry

8.208. The Dover & District Chamber of Commerce & Industry (subsequently part of a mergerwhich formed the Kent Maritime Chamber of Commerce Ltd) represents businesses in the District ofDover—Dover, Deal, Sandwich and the inland villages from the coastline. It said that there were virtu-ally no banking facilities outside the three major towns. Consequently, customers wishing to use bankingservices would have to travel to either of the major towns or to Canterbury to obtain banking services.The banking services within the major towns were adequate, the only issue being that customers wantedto see lower bank charges.

Mid Yorkshire Chamber of Commerce & Industry Limited

8.209. Mid Yorkshire Chamber of Commerce & Industry Limited (MYCCI) served the metropolitandistricts of Calderdale, Kirklees and Wakefield and was actively involved in the provision of businesssupport in the region through various partnerships with Training and Enterprise Councils, BusinessLinks, the Regional Development Agency and with organizations in the private sector.

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8.210. MYCCI told us that most of its members felt they had not been well served by the banks, inparticular as regards charges and clearing times. Most of MYCCI’s evidence on this related specificallyto micro-businesses with a turnover of up to £250,000.

8.211. After considering case studies it had received, MYCCI believed the evidence indicated that ade facto monopoly existed based on the similarity of services offered to SMEs and available from eachbank, which effectively limited choice. This had developed as a result of a succession of bank mergers,as distinct from a contrived monopoly.

8.212. MYCCI said that the banking sector was dominated by four or five key players and the supplyof finance for business start-ups, SMEs and business growth generally was restricted to these mainplayers in the market. They tended only to compete for new businesses, rather than encourage existingbusinesses to switch from other banks. There was no alternative to the high street banks for the provisionof banking services and money transmission services to SMEs and this was surprising considering therecent climate of building societies converting to high street banks and the development of Internetbanking. The former building societies were unwilling to get involved in the SME sector, and there wasalso a lack of sophistication among the SMEs in knowing what alternatives were available. MYCCImembers were made aware by capital equipment suppliers of asset financing but tended not to usefactoring.

8.213. A main concern was that each of the lenders applied the same criteria and procedures and tobe rejected by one meant being rejected by all, undermining the confidence of an SME. Members tendednot to shop around, but to go where they had some association. Those who did best, however, tended tobe those who took assistance with the preparation of their proposals from organizations outside thebanks. Once with a bank, there was a feeling that all banks were the same, so there was no benefit fromswitching banks. Banks also tended to offer a total package of facilities, and SMEs expected them to doso, for example a loan account required (in facility letters) a current account for transfer of the loans,while overdrafts were necessarily current account based.

8.214. MYCCI said that the monopoly effect of restricting choice in the supply of banking servicesto SMEs could be argued to have manifested itself through the rationalization of the high street branchnetwork, abnormal profits, the high number of business failures, a low business birth rate, the phenome-non of house price inflation and the lack of entrepreneurial spirit in the UK. It had been documented inthe media during the 1990s that traditional banks had closed a number of branches and replaced themwith one focal business centre. One argument for this had been increased competition. However, MYCCImembers believed banks had merged so that they could compete effectively in a global market with thenet result of stifling competition even further in the UK market. In many cases the mergers had resultedin branch closures due to cost-cutting exercises and duplication of services, but this was to realize share-holder expectations rather than be in the interest of SMEs or the customer.

8.215. Another issue MYCCI believed had resulted directly as a result of branch closures, andindirectly due to high street banks enjoying dominance in the UK market, was the demise of thetraditional high street bank manager and his local knowledge. This role was crucial not just as a providerof finance, but as an adviser that worked to build long-term relationships rather than to see short-termgain. The demise of the traditional bank manager had created a breakdown in the development of effec-tive working relationships with SMEs, a significant component in any successful enterprise as it alloweda more mutually flexible working relationship. MYCCI members had complained as the bank manager,now no longer locally based, behaved more like a sales manager and had no understanding of their indi-vidual business or local conditions. Local facilities (with the exception of HSBC) tended to be confinedto cash transactions.

8.216. MYCCI said that a further issue was the charges banks set for money transmission services.Members believed charges were too high, and that the banks were ‘heavy-handed’ in their approachwhich caused concern as SMEs were the least equipped to monitor their own cash flow and anyoverzealous charging by their bank could result in failure of a business. MYCCI felt the banking sectorhad not only to realize but also to accept that in many cases of business failure, the banking service pro-vider had had a pivotal role to play. MYCCI found that bank charges for businesses had always beenunderstood to subsidize free banking for personal customers, the argument being that, like any otherbusiness, banks had to cover their overheads plus a margin—the problem was that the margin could begreat because there was little option to go elsewhere.

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8.217. It was a well-established fact that the main reason an SME failed was because of short-termcash-flow problems, which put the enterprise in the position of not being able to meet its day-to-daycommitments. Many businesses also failed because secured creditors could realize some or all of theiroutlay by liquidating those businesses. In most cases, the secured creditor that normally liquidated abusiness was a high street bank.

8.218. A consensus reached with a majority of MYCCI’s members was that in most cases the bankswere the main culprits in a business failure, when on the balance sheet an SME was financially sound butthe bank had declined to extend or offer short-term financing solutions. This suggested that there washypocrisy from the banks because SMEs argued that in an upbeat economic climate it was the banks withsurpluses that were encouraging businesses to borrow to expand, but on a downswing they were the firstto limit any further borrowing at the time when cash flow was contracting. MYCCI accepted that bankswere perhaps less likely completely to withdraw facilities than they were five or ten years ago. However,there was a perception that below a certain level, banks still preferred to lend on overdraft, which couldbe immediately withdrawn, rather than term loans; there had been occasions when overdraft facilities hadbeen reduced across the board when banks had become overexposed to loans elsewhere.

8.219. MYCCI believed an additional issue was the question of what was deemed equitable for highstreet banks in taking risks posed by SMEs. Banks argued that there were no new entrants to providebanking services to SMEs because the risk was so unattractive, and if they were seen as making a profitfrom engaging in that risk, then it was just and equitable and not taking advantage of a dominant positionresulting from the lack of competition. MYCCI believed this explained why the UK had such a low busi-ness birth rate.

8.220. Evidence to support the banks’ negative policy towards the SMEs was illustrated in the pro-vision of the SFLGS, where the Government took 75 per cent of the new risk but the banks that carriedthe remaining 25 per cent still sought full collateral guarantees, which in most cases were not available.This policy from the banks demonstrated why government-sponsored business finance initiatives werenot effective in expanding the business birth rate in the UK, because even when the majority of the riskwas being borne by the Government, the banks were still hesitant. MYCCI said that the importance ofthis issue should not be overlooked; such an overprudent policy by the banks was damaging the UKeconomy even when the government initiatives cushioned the risk exposure of start-ups and SMEs ingeneral. Opportunities of establishing successful SMEs had been missed because there was no alternativesource of finance other than the banks.

8.221. It was MYCCI’s experience that banks tended to be uninterested in providing small loanswhere the income from them would not justify the administrative costs. Following the centralization oftheir activities the banks were less interested in providing loans to very small businesses in associationwith loans from the Calderdale Business Trust established in the 1980s as an unsecured lender of lastresort. In spite of the loan being totally unsecured and at a nominal rate of interest, banks were notinclined to accept this as quasi-clients’ funds. This problem was exacerbated by a lack of sources ofequity for small local businesses.

8.222. The West Yorkshire Enterprise Agency, MYCCI’s business start-up subsidiary, suggestedthat there was a marked difference in the business birth rate and survival of SMEs where alternativesources of finance to the high street banks were available. MYCCI believed that liquidity ratios adoptedby the banks compounded the situation in relation to the uniform policy adopted by all the high streetbanks to the SMEs. The area of contention was that not only were banks hesitant in dealing with SMErisk, often rejecting loan applications if security could not be provided, but also the level of funds that atstrategic level were made available was restrictive. It was felt that the current liquidity ratio favoured thepersonal banking sector, where there was greater competition, aided by free banking and twice the levelof funds available for the personal customer in comparison with the SME.

8.223. MYCCI said it seemed that real wealth creation opportunities had been overlooked by thehigh street banks, and there was evidence to suggest that many potential entrepreneurs were going over-seas to establish their own businesses.

8.224. MYCCI said that the answer to ensuring that greater competition was brought to bear in theprovision of banking services to SMEs would be to introduce new entrants and the provision of a greaternumber of alternative sources of finance being available to the SMEs, from within existing players in the

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banking sector and from government business support agencies. Greater transparency of charges wouldencourage SMEs to shop around and switch between banks; banks had also been less active in encour-aging SMEs to adopt new technology than was the case with personal customers.

8.225. MYCCI also said that the BoE could play a more active role in ensuring fair play in thetreatment of SMEs, especially when the central bank was the main regulatory body in the market. TheBoE could alter the liquidity ratios of all the banks in the market so as to allow equal proportion of fundsto be lent to personal customers and SMEs in relation to deposits held. This would have two effects: first,it would restrict the amount of funds available to fuel house price inflation, and second, it would stopnew converted building societies from concentrating on personal banking and force them to lend morevigorously to SMEs.

8.226. Finally, MYCCI said it was widely accepted that SMEs were the future of any progressiveeconomy and the market leaders of tomorrow, therefore they should be afforded a level playing field notonly in the provision of banking services but also by the Government.

8.227. MYCCI was also asked whether ethnic communities found it more difficult to establishrelations with banks. It did not think this was the case in its area, although such businesses tended to bemore self-reliant and not to need such support from banks: but those that did use banks did so as effec-tively and in some cases more effectively than other businesses.

Northamptonshire Chamber of Commerce

8.228. Northamptonshire Chamber of Commerce told us that it represented 1,500 businesses, themajority of which were SMEs; its response was based on the views of members of the Chamber’sfinance and taxation panel. It believed that the major clearers constituted an effective oligopoly with thedominant share of the small business market between them. They offered broadly similar services;comparisons of account tariffs and overdraft fees indicated that, although there was some variation withrespect to individual charges, overall there was a high degree of uniformity in the overall cost of bankingservices to SMEs from different providers. The ability of SMEs to shop around in search of lowercharges was further hindered by the complexity of charging structures and the lack of readily comparablecharging information. There was also concern about the use of arbitrary ‘management fees’ by somebanks irrespective of the volume of transactions undertaken on an account.

8.229. New entrants to the market needed to be encouraged; in particular, they needed assistance toenable them to access the BACS system. Legislation might be required in order to guarantee newentrants to the market access to this system. Significant concern was also expressed that the efficiency ofthe bank system did not appear to have kept pace with the development of IT in other spheres ofeconomic life.

8.230. Panel members suggested that it was significantly harder for a business to change bank thanfor an average personal customer. In part this was a function of the greater volumes of transactionsundertaken, but it was generally felt that the banks had no incentive, once business customers haddecided to move an account to a competitor, to maintain a high level of service and ensure a speedy andtrouble-free transfer. Regulation should be considered to ensure adequate standards of performance frombanks in these circumstances.

8.231. Businesses that handled significant volumes of cash and cheques were often constrained intheir choice of bank to those with a branch in their immediate vicinity: a particular issue for the 40 percent of SMEs located in rural areas. Recent branch closures had exacerbated this problem. The develop-ment of online and telephone banking would not address this problem, even if it did enable a wider rangeof providers to offer some banking services to SMEs.

8.232. A general concern was also expressed about the quality of advice provided by banks toSMEs. Banks were looking for new avenues to generate income through the offer of advice or monitor-ing programmes, with a fundamental conflict of interest between banks and their customers and thedangers of inappropriate advice being offered at critical stages of business development to the detrimentof SMEs. This problem was generally seen to have been exacerbated by the commonly perceived de-skilling of bank staff in recent years. Banks should be encouraged to recommend that their customers usethird party independent sources of advice. Significant concern was also expressed about the preparedness

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of banks to lend to SMEs, it being far easier to obtain credit as a personal customer than as an SME. As aconsequence SMEs must frequently bring in external professional expertise in order to negotiate creditfrom the banks and other financial providers creating additional cost and acting as a disincentive tomuch-needed investment.

Oldham Chamber of Commerce, Training & Enterprise

8.233. Oldham Chamber of Commerce, Training & Enterprise (Oldham CC) said that there was awide choice of banks offering specific business accounts in the area and there was quite a difference inthe charges levied on business accounts. However, businesses were reluctant to change banks even ifthey were unhappy with the service. It was clear that businesses needed to shop around for the mostappropriate account, but many small businesses lacked the confidence or expertise to evaluate the ser-vices on offer. Oldham CC was reluctant to blame the banks for this. An increase in banking via theInternet or provision by the new Small Business Services of up-to-date banking information could pos-sibly encourage businesses to look for the most appropriate account.

Trade associations, SME representatives and advisory bodies

Association of Convenience Stores Ltd

8.234. The Association of Convenience Stores Ltd (ACS) represented the interests of over 23,000retail outlets operating in neighbourhood areas. These stores were characterized by the convenience theyoffered in terms of location, opening hours and range of produce, offering local communities vital accessto groceries and a range of other services in rural and urban locations. Convenience stores’ income camefrom customers buying small amounts, such as bread and milk, regularly and paying in cash.

8.235. The fact that convenience stores were essentially cash businesses had very real implicationsfor the type of banking service they required. Since they banked large amounts of coins and notes it wasvital that they had continued access to local counter services. Regular cash bank transactions, however,meant that they incurred frequent charges. Convenience stores operated on tight net profit margins andrelied on a competitive supply chain in order to minimize their costs. A competitive banking market wasa crucial part of this and it was vital that good-quality products were available with charges that did notcripple their businesses. Currently, competition between providers of these services was muted andworked to the detriment of small retail businesses.

8.236. ACS found from a recent survey that the majority of its members used the main clearingbanks for their day-to-day banking needs. Half of those surveyed used one bank account for all theirbanking needs. In the main, its members did not use their own personal accounts for their businessbanking, nor personal banking facilities for their business needs. None of ACS’s members had switchedbank accounts over the last two years, the majority of members having been with their current bank for atleast five years and some for more than 15 years. It was believed that this was because they had beenprovided with very little incentive to change. Indeed alternative terms offered by opposition banks weresimilar and not sufficiently attractive to make a move worthwhile. Another disincentive for small busi-nesses was the time and resources it took to switch bank accounts and the general perception that itwould not be in the interests of the business. ACS believed that the clearing banks had a captive marketand for the small business there was very little to choose between the providers.

8.237. ACS believed that the current market for the supply of business banking services to SMEsmeant that competition was limited. There were a small number of providers. The customer base waslarge and supply could exceed demand. There was a high degree of standardization in the basic bankingservice offered to business customers. The majority of customers required no more than a basic bankingservice, but without it were unable to run their business. There was also a high degree of transparency,with terms and conditions being widely publicized.

8.238. The only area of business banking where some element of competition appeared to exist wasin the case of new start-up businesses. Some banks participated in schemes with local training and enter-prise agencies, marketing their services to new businesses alongside more general help and advice. A

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small number of banks offered special terms and conditions to small businesses for the first year or two,but only on condition that a personal account be held with that bank or on completion of a sponsoredtraining course. ACS did not believe that free banking for start-up businesses, with conditions attached,constituted a truly competitive environment and it was further concerned that such favourable terms werenot currently extended to existing business customers by any of the clearing banks. The position of smallbusinesses within the marketplace meant that they did not enjoy, either separately or collectively, a pos-ition of sufficient power to counteract competitive pressures.

8.239. ACS believed that the lack of effective competition between the major clearing banks for theprovision of business banking services had had a significant and negative impact on its members. It hadresulted in unsustainable levels of charging unresponsive services that were no longer conducted at alocal or personal level, and a marked imbalance in the contractual terms between the clearing banks andSMEs.

8.240. ACS believed the greatest banking problem for SMEs was the level of charging. 87.5 per centof its members who were surveyed believed that the level of charges applied to their account wereunacceptably high across all categories of service, although the majority did say that the level of chargeswas transparent. For example, across all the clearing banks the charges for handling cash were around50p per £100. In contrast Girobank offered the facility at 9p per £100. As a result of this differential,many of its members opted to use Girobank for this facility while using one of the clearing banks for allother services. Banking was an essential service for small businesses but came at an extremely high pricewhichever provider was used.

8.241. The closure of banks and the withdrawal of the SME functions from branches created anadditional burden on small retailers in terms of time and income. The two main problems were theadditional time taken to travel to the nearest bank and the loss of personal relationship between localbusinesses and their banks. This was particularly important given that over 87 per cent of retail cus-tomers regularly used counter services to bank cash. ACS believed there had been erosion in the personalrelationship between banks and SMEs due to high staff turnover in bank branches. This had led to anegative effect on the quality of service offered to SMEs. It was important to small retailers that theperson in the bank managing their account understood the needs of their particular business, in manycases local managers being able to vary the terms and conditions applicable to business accounts, anability greatly valued by its members. However, with the move away from personal local banking,smaller customers were able to vary the standard service only in a nominal way, and the concessions itsmembers received were small and not evidence of true negotiation.

8.242. ACS believed that as a result of a lack of competition in the supply of banking services,SMEs were being disadvantaged in their relations with banks both in terms of the prices charged and thequality of the service delivered.

8.243. ACS therefore believed that competition in the market was minimal and restricted. Theclearing banks were able to exercise considerable power in the marketplace and dictate terms to theircustomers. The high degree of transparency in terms and conditions had led to standardized services,further reducing the power of the consumer.

8.244. ACS felt that business banking services to the smallest businesses should be offered on thesame basis as personal banking services, with no charges being imposed for routine transactions and ahigher rate of interest offered on current and deposit accounts. The relationship between clearing banksand their small business customers should also be regulated.

Remedies

8.245. Commenting on the CC’s statement of hypothetical remedies, ACS said that it believed acomplex monopoly existed within the marketplace, enabling the banks to exercise considerable powerand dictate unfavourable terms and conditions to their small business customers. This, in turn, under-mined the competitive position of small businesses and the supply of goods and services to the general

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public. It was particularly concerned about the high levels of charges imposed on SMEs, and thediscrimination between business customers and personal customers. It therefore believed that action mustbe taken to address these concerns as a matter of urgency.

Possible regulation of charges, terms, conditions or profits

8.246. ACS supported the suggestion that the rate of interest payable on current and deposit accountsbe more closely regulated. In particular, the rate of interest should be more closely aligned to the benefitsof the funds to the bank, and should be payable on balances held in current accounts. Banks should alsobe required to notify customers from time to time of the different accounts and facilities available to helpsmall businesses manage their cash more effectively.

8.247. Any remedy relating to interest payments would need to be accompanied by correspondingregulation of charges to avoid the latter being increased to compensate for more competitive interestrates.

8.248. The scale and nature of the charges imposed by the clearing banks for routine transactionswere the area of greatest concern for its members and which contrasted with the offer of free personalbanking, with a widely-held view that charges applied to routine business banking transactions were usedto subsidize services and incentives offered to personal customers. ACS believed there was no objectivejustification for the discriminatory charging structure that currently existed between personal and busi-ness accounts. In many cases, there was little difference in the way in which these two types of customerused banking services. It believed that business banking services to the smallest businesses should beoffered on the same basis as personal banking services, and supported the CC’s recommendation toimpose a requirement for the main clearing banks to adopt the same structure of account charges andinterest rates for any given level of activity regardless of the nature of the customer. It also believed thatthe facility that allowed balances in current accounts to be offset against outstanding debts, such as mort-gages or loans, should be extended to business customers.

8.249. ACS believed that the charges applied to business accounts should be closely related to thenature and level of service provided. At present, blanket charges were applied, ostensibly to fund a sys-tem of customer account managers, small business advisers or services such as night deposits, regardlessof whether these services were used or valued by the business customers. Routine transactions should befree of charge and additional services provided according to a set tariff and either agreed when theaccount was opened or paid for as they were used.

8.250. Banking services might be equated to the provision of other essential business services suchas utilities. Without an effective and efficient banking service, small businesses found it extremely diffi-cult to run their business. The overall level and annual increases in these charges should therefore beregulated in a similar way to other utility providers. ACS supported the proposal to introduce a centralprice control to ensure that fees and charges were kept at a reasonable level and excessive profits werenot to be earned from the small business sector.

8.251. The CC had asked for views on whether a threshold should be introduced above which theseremedies would not apply. The effects of a lack of competition in the market were felt disproportionatelyby the smallest businesses, for which high levels of charges might be punitive. These businesses werealso the ones more likely to use banking services and have a level of activity more closely aligned topersonal banking customers. ACS believed that these remedies should be applied across the small busi-ness sector, but would not oppose the introduction of a different threshold based on the turnover of theaccount to focus the benefits on those most particularly affected by the anti-competitive structure.

Behavioural remedies to remove barriers to entry

8.252. ACS’s concerns in this area related particularly to the ability to switch providers and themaintenance of an effective and comprehensive branch network. For the reasons set out above, smallbusinesses were unlikely to change their bank unless there was sufficient incentive to do so. Remediesdesigned to introduce more favourable terms and conditions were likely to result in greater competitionas providers sought to differentiate themselves to attract and retain customers. It would therefore expectthere to be a greater incentive to consider switching bank account. Nevertheless, more could be done to

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assist small businesses wishing to move their accounts. ACS supported the suggestion that the OFTmight approve a minimum industry standard to facilitate switching. This might include a prohibition onpenalties not related to specific costs for switching; a guaranteed minimum time period for the switch tobe completed; portable account numbers; and a requirement for the bank to bear the costs of switching.

8.253. The tendency to bundle services might also impact on a customer’s willingness to considerswitching. For example, some banks imposed a requirement to have a current account before providingaccess to deposit or lending facilities. ACS believed that the imposition of such a condition was anti-competitive and should be prohibited. This would enable small businesses to organize their bankingfacilities according to the needs of the business. It would also encourage and support niche banking pro-viders. For example, many retailers used Girobank for banking cash, as their costs were considerablylower than those applied by the high street banks.

8.254. ACS supported the CC’s proposal that banks be required to submit details of their interestrates and charges to the BBA, but was disappointed that this central information would only be providedto the banks on request. It believed that this information should be centrally provided and accessible tocustomers. At present it was difficult to compare terms and conditions between the banks, particularly inrespect of deposit accounts and loan facilities, because information was provided on a selective basis. Acentrally held database of like-for-like charges and interest rates would greatly assist customers andencourage competition in the marketplace. It therefore recommended that this database be made publiclyavailable on the Internet.

8.255. ACS supported the suggestion that banking services should be made more mobile. Inparticular, the ability to pay money into an account held with one of the main clearing banks through apost office, sub post office or a branch of a different bank would be extremely welcome. It also believedthat the proposed community banking service should be available to business customers as well. Thisservice should, however, be provided at no extra cost to the small business customer.

Behavioural remedies to safeguard SMEs in their relationship with banks

8.256. ACS believed the relationship between banks and their small business customers to be inade-quately regulated at present. This was in direct contrast to the relationship between a bank and itspersonal customers, where consumer safeguards were built into the contract regulating the account. Anew Code of Conduct should be agreed between representatives of the main clearing banks and theirsmall business customers, to be approved and regulated by the Financial Ombudsman or the FSA. TheCode should cover the terms on which banking services should be supplied, the marketing of such ser-vices, minimum compensation for overcharging, prohibition of excessive or unnecessary security, guar-antees, collateral or insurance, minimum notice periods for changes to the account or withdrawal offacilities and the introduction of consumer dispute arrangements. All documentation should be drawn upin conjunction with small business representatives and the language used should be clear.

A possible tax, licence fee or fund

8.257. ACS was concerned that any tax might simply be passed on to small business customers andwould result in little direct change in the anti-competitive relationship between them and suppliers ofbanking services. It therefore recommended that action to tackle excessive profits be directed in the firstinstance to regulating prices and preventing the imposition of excessive charges by those complexmonopolists in the market.

Possible structural remedies

8.258. ACS believed that structural remedies should only be considered after all behaviouralremedies. Any requirement to divest branches or parts of the business would involve considerable dis-ruption to customers, and this at a time when changes in the branch network appeared to have settleddown.

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8.259. It did, however, believe that banks should be required to make explicit the link between themand their parent company, so that customers could make an informed choice of supplier.

Bank Mediation Services

8.260. Bank Mediation Services (BMS) is a specialist at negotiating settlement of banking problems.Its services were distinct from the recalculation services provided by other organizations—it would, forexample, examine whether a legal charge was open to question. The Banking Ombudsman, on the otherhand, it claimed, was funded by the banks, and carried out a largely paper exercise, and was not involvedin legal technicalities or in examining the validity of key documents. It had settled some 300 to 400 casesover the last two years; in only a minority of cases brought to its attention was the bank’s positioncorrect. The solicitors with whom it worked were generally financed by legal aid, the future of whichwas in question.

8.261. BMS acknowledged that there had been some improvement over time in that more infor-mation was now provided on bank statements. However, whereas the Consumer Credit Act 1974 appliedto consumer purchases up to £25,000, there was no protection above this level, including no cooling-offperiod and little explanation of the risks.

8.262. One of the major points of the cases it saw was that the case often did not break any currentbanking law, but the bank had acted in a way that was unethical and morally wrong. BMS believed thatbanks used their strengths to persuade people at the start of a business venture to pledge their assets tothe bank without fully understanding the situation. There were, for example, cases in which a husbandhad secured all business debts on a property, and a wife in signing a legal charge without proper advicehad become liable for debts far greater than was thought. Often small amounts of borrowing weresecured on an all-monies charge, all property being at risk in the case of business failure. The bank didnot accept any obligation to notify a guarantor or surety that a debt had increased substantially. Therewas also little or no explanation of the penalty rates to be applied should agreed limits be exceeded.Although there had been some improvement in these matters, it was insufficient, and the banks wereequally bad in their obscurity on these points.

8.263. There was often delay before banks tried to obtain repayments, or as a result of dispute, butsuch recovery of debts after some years earned the bank large sums of interest (sometimes at ratescharged as unauthorized overdrafts): as the debt increased, so did the security. The bank’s legal costswere also covered on an indemnity basis. BMS believed that once a bank account ceased to operate or aformal demand was issued, the amount owing at that point should be frozen as ‘the debt’, and discussionshould follow to decide on ways in which the debt could be repaid, to give the opportunity for mediationbefore recourse to litigation. The debt should not increase if the dispute continued to be argued throughlitigation or by mediation.

8.264. BMS also believed that any guarantee or mortgage document should clearly show a simplesummary at the end of the document highlighting the important points within it. Each major point shouldthen be signed alongside by everyone involved in the document—not initials, but a full signature at eachitemized point.

8.265. BMS believed that banks should provide clear details whenever the family home was used forsecuring borrowings. All too often people failed to realize that they could lose their home if they did notrepay the bank when things went wrong.

8.266. There were also cases of errors by the banks. One source of error, for example, was that if aninterest rate were not put into the system, the system calculated at a penal rate. Banks appeared not tohave systems to pick up such errors. Revisions in interest rates had also sometimes been implementedwithout telling the client. In other cases, the bank had failed to inform customers what interest rates wereput on the system. Although some banks had started to include on bank statements details of interestrates that would apply if limits were exceeded, there was little explanation: it was still difficult for cus-tomers to appreciate whether the higher rate was charged only on excess borrowings or, as was some-times the case, total borrowing. If a client had been notified of a higher interest rate (such as a MonthlyManaged Rate) being applied, and the bank could verify that, there was less cause for complaint, as longas the rate charged was fair.

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8.267. BMS also said that the bank at times might reduce an existing overdraft limit to below thecurrent overdraft level. The system then calculated interest on the difference between the current over-draft and the reduced overdraft level (or sometimes the whole of the overdraft) at the unauthorized rate ofinterest. Also at other times the bank might remove an agreed overdraft limit with very short notice andthen say that as there was no limit in place the bank was entitled to charge the penal or unauthorized rateon all the borrowings. BMS believed that if a bank reduced an agreed overdraft limit, it should not beable to charge the penal or unauthorized rate of interest just by the fact that the bank had reduced theoverdraft limit. The customer must be given a reasonable period of time to reduce the current overdraftbelow the new agreed limit. During that period the bank must only charge the agreed rate of interest onthe entire overdraft.

8.268. On the potential for new competition in the market, BMS believed other financial institutionstended not to have experience of the clearing banks, and did not want to accept the risk; small businessesdemanded more input and more knowledge than was the case for many other financial services providedby the banks.

Brandenburg Securities Ltd

8.269. Brandenburg Securities Ltd (BSL), a member of the Foreign Banking and Securities HousesAssociation, provides corporate finance advisory functions to SMEs seeking to buy or sell a business,raising finance, seeking joint ventures, flotations or other corporate actions.

8.270. BSL told us that it did work for overseas banks, some of which intended to enter the UKmarket. However, BSL believed such entry was constrained, first, by capital adequacy requirements, andsecondly, by the need to be confident in the controls over the business processes, in particular the con-fidence to run a large branch network. Overseas banks also did not appear to be ready to enter the UKmarket via the Internet.

8.271. SMEs encountered banks both as borrowers and users of banking services. The banks’ busi-ness could not get too large, due to the limitation on their capital; hence in order to increase their profit-ability they had to increase the return on assets, rather than the total value of their assets. There were alimited number of ways in which they could do this: either by increasing their margins, which was noteasy, or increasing their off-balance-sheet activities, for example in undertaking clearing and otherservices.

8.272. BSL believed that the main banks were in business not so much to lend as to take in cash onwhich they could generate returns, particularly from fees for large numbers of transactions. Clientswanting to borrow found the requirements imposed by banks to be rigid in terms of the proposition,exactly how much was to be lent, when that would be repaid, the basic terms on which the loan wasgranted and, in particular, in their requirement for security. If there were insufficient asset cover, a bankwould want a personal guarantee, and even if there were some asset cover, a bank would still want anelement of personal guarantee. Hence, no security, no loan from the bank, rather than a bank wishing tocharge more for unsecured loans. In most cases, bank requirements for security were not unreasonable.But in some cases security would not be available and unsecured lending would be appropriate, forexample when a good management team was in place; when a substantial if not sufficient level of collat-eral was available; where the loss of collateral or guarantees would have a serious effect; and where acompany wished to borrow and was well known to the bank.

8.273. SMEs could of course go elsewhere for different forms of lending, such as debt-relatedfinance, but BSL believed that good advisers to guide them were few and not well rewarded. Asset-basedfinance, leasing, factoring or confidential invoice discounting were surprisingly easy sources for loans,since they were subject to a significant element of competition, even though a significant proportion ofthese services were provided by the banks’ own subsidiaries. There were no disadvantages to using them(except that they were available only for ‘typical assets’ for which there was a good second-handmarket), and the cost of such alternative forms of finance was reasonable. Indeed the whole culture of theproviders of such finance was entirely different to that of the clearing banks.

8.274. The rigid approach that the banks took was due to the gradual changes in their structure. Thisresulted from changes in financial service regulations, which took out the previous role of the bankmanager: all but one of the main banks had become providers only of their own services, and since bank

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managers advised only on their own services, they had become less respected as advisers. Additionalfactors were the structural changes in the banks, with closure or part-closure of bank branches and aconcentration of activity on business centres for larger SMEs, and on contacts through call centres forsmaller SMEs. It was no longer possible to call even relatively junior officials directly. This meant thathead offices could keep control over its branches. The main clearing banks were structured to ensure thatthey got good business by their various credit committees and credit approval systems, designed to takeaway the approval of credit from the personnel that actually sold such facilities: a matter that could befrustrating for SMEs. BSL believed that more authority should be given to the front-line people, byadopting ‘detective’ rather than ‘protective’ approaches: ie monitoring the performance of loans thatwere made, rather than constraining the ability to make loans.

8.275. BSL believed that relationships between banks and SMEs had improved during the last tenyears, although there was some difference in attitude towards banks, and none had re-established thedegree of relationship that existed in the 1960s or 1970s. BSL’s clients believed there were too manystaff changes in the banks. SMEs wanted a familiar, reliable relationship with bank staff: the only way asmall business could manage a relationship with large organizations such as clearing banks was todevelop such a relationship.

8.276. It was generally thought that there was no point in SMEs switching between banks, first,because charges were similar and secondly, because SMEs were not convinced they would get a betterservice. In practice, BSL thought switching banks was straightforward as long as the old account waskept open for six months, but if a floating charge existed, an SME should consider switching morecarefully since it was likely to be charged for the work undertaken by both the old and the new bank.BSL advised its clients against moving unless they had a very legitimate reason to do so, in part becausea history of frequent moving could reflect badly on an SME, indicating that an SME had bad relation-ships with its banks and a feeling that this was the SME’s rather than the bank’s fault.

8.277. The main difficulty BSL saw in entering the market was lack of capital. For purposes ofillustration, a single branch in the City of London could require some £2 million a year in overheads. Togenerate sufficient income to cover such costs on the basis of deposits, some £100 million of depositsmight well be necessary. That level of deposits in turn might require some £12 million to £15 million ofcapital, depending on the attitude of the banking regulators. This was an expensive sector to enter, butventure capitalists were not normally prepared to invest in banking or deposit-taking enterprises.Although the UK banking system was regarded as well regulated, it could be excessively rigid andcontributed to the loss of relationships between banks and SMEs and the split between authorization andmarketing of funds, and the need, as BSL saw it, for the empowerment of bank staff: the average clientdid not know his bank manager. As to the other skills necessary to enter the market, credit risk skillswere relatively easy to find, but more difficult were skills in managing interest rate risks, liquidity, andforeign exchange risks. Another difficulty was the need to obtain external services, including use ofanother competing bank for clearing services, since to do one’s own clearing was too complicated for asmall bank. It was noted that clearing services were only available through the clearing banks them-selves, as these banks controlled the clearing systems. The amounts charged to small non-clearing banksby clearers for use of clearing services needed to be carefully scrutinized, as it might well form a barrierto effective competition in banking services generally.

8.278. The majority of new entrants in the UK had been started by overseas banks. However, theiractivities did not require branches. Other examples of new entrants, including the Virgin One account,were companies with substantial funds available: even the Virgin One account, however, was merely a‘shop front’ and SMEs would require a much more comprehensive, therefore potentially complicatedservice. It was currently too hard to enter the banking market, and if a company had no track record inbanking, it would face even higher scrutiny by the regulatory authorities. BSL believed that one solutionwould be for the transfer of branches to such overseas banks, rather than their closure. A divestment of30, 50 or 100 bank branches to a particular overseas competitor would be appropriate. A parallel wasdrawn with the arrangements made in the brewing industry with regard to ownership of public housessince the 1970s.

8.279. Reluctance to encourage entry into the market was in part based on historic examples, such asthe secondary banking problem, but these were due more to regulatory failures which need not beallowed to recur: entry could be less exclusionary. BSL would not be surprised if the regulators them-selves did not set up excessively tight regulations that deterred competition; for example, criteria thatrequired banking experience elsewhere. The spirit of entrepreneurship was not common among the

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banks, and few current bank managers could be persuaded to start their own banks. BSL would welcomea more enterprising environment, but it was not as easy as it could be to set up a small bank catering forSME business given the need for capital, for management skills and assistance from existing clearers.

British Bankers’ Association

8.280. The BBA told us that it was the principal UK financial services trade association, represent-ing more than 300 banks from over 60 countries. A significant number of its members were active in theSME market, both in the UK and in their home markets.

8.281. It was committed to transparency in the provision of banking services and to the developmentof open and healthy competition in financial markets. As there were differing views within the industryabout the extent of effective competition in the market for banking services to SMEs, the views werethose of the BBA executive on the likely impact of the hypothetical remedies on the industry as a whole.

8.282. The hypothetical remedies were based on the assumption that the market for banking servicesto SMEs did not operate efficiently, and that profits generated by banks that operated in these marketswere therefore excessive. The BBA agreed that greater transparency was effective in creating efficientmarkets and improvements in transparency should be a priority in this particular market. Any analysismust, however, take account of the risk inherent in this market. The return achieved was highly gearedaccording to the experience of having to write off debts, as many banks had found to their cost, and itwas therefore most important that proposed controls did not reduce the capacity of the industry to absorbperiodic setbacks.

8.283. Efficient markets also depended upon the ability of service providers to differentiate them-selves from their competitors. The UK banking market was mature, and banks competed vigorously fornew (and each other’s) business in the SME market. To do this effectively they needed to be able to offera range of products differentiated by cost, service level and delivery channel, matched to the needs ofspecific customers. Any proposals to regulate charges, prices or terms and conditions could suppress theclimate for innovation and differentiation. In this regard, the BBA noted with interest that some of theproposed remedies in terms of product offerings were currently available from banks that regarded themas a competitive edge.

Possible regulation of charges, terms, conditions or profits

8.284. Commenting on a requirement not to discriminate between short-term and long-term deposits,or between customers, and to pay a rate of interest more closely related to the benefit to the clearing bankof the funds, the BBA said that banking intermediation consisted of the transformation of liquidity andinterest maturities from shorter to longer and the aggregation of amounts from smaller to larger, therebyadding value. It was therefore to be expected that shorter-dated (or short-notice), smaller deposits wouldreceive a lower rate of interest than longer-term and/or larger deposits. Historically, the size of the differ-ential had fluctuated in reaction to economic conditions affecting supply and demand for funds of differ-ent sizes and maturities. For example, building societies had seen long-notice deposits as a stable basefor funding their mortgage commitments and had been prepared to pay more than would appear justifiedby money-market rates. The very short end of the yield curve was not stable and there was no clearrelationship between the value to a bank of instant access funds and base rate. The issue was one oftransparency, where good information would help SMEs to make informed choices between differentproducts and different suppliers.

8.285. The method of quotation of rates should not risk confusion for the customer. Research hadshown that some customers understood a blended rate more readily and might be confused by a ratequoted as base rate less a specified percentage.

8.286. On a requirement to notify customers periodically of the availability of set-off and sweepfacilities and of the benefit to individual SMEs that would have been received over the previous 12months had such facilities been used and a requirement not to charge for such facilities, the BBA agreedthat it was good practice for banks to remind customers regularly of the availability and benefits of

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products, and there would be provisions in the proposed Business Banking Code to this effect. However,banks should be free to differentiate on pricing, and any charge should be transparent to the customer.Sweep facilities were set up to suit customers’ cash-flow planning requirements and it could be a consid-erable task to reconstruct the position. Requiring such a capacity of new entrants might raise the barriersto entry—technology, such as the ability to manage same-day inter-account transfers via the Internet,was in any case overtaking these facilities.

8.287. Price constraints such as requiring these facilities to be provided free tended to distort themarket in favour of some players and could make a market unattractive to potential new entrants.

8.288. On a prohibition on discrimination of charges between personal and business accounts and/orbetween personal and SME customers, the BBA said that treating larger SMEs in a similar fashion topersonal customers did not make good business sense in view of their greater transaction volumes andgenerally more complex banking needs. Any shift in price structure in favour of SMEs towards that ofpersonal customers risked a rebalance of costs against personal customers. While there might be a casefor treating some micro-businesses in a similar way to personal customers (which in effect happenedalready through self-selection), it would be difficult in practice to set a threshold above which services toSMEs were differentiated, without creating an artificial limitation on growth aspirations of businesses.The existing purposive test was more effective in this respect.

8.289. In practice, some smaller businesses were already self-selecting as to whether to operate apersonal or business account. Estimates varied, but possibly up to 30 per cent of micro-businesses werefunded through personal accounts. However, the principle of separating personal and business affairs wasgood practice, enabling customers to track business cash flow more accurately. Therefore any additionalmeasures proposed by the CC should not encourage businesses to make decisions that mitigated againstgood financial practice by smaller businesses.

8.290. SMEs were not a homogenous group in their requirement for relationship management, andresearch indicated that many businesses appreciated the benefits of a single point of contact in their bank.Banks had responded to this with a range of relationship management propositions for different customerneeds. The BBA agreed that the nature of any relationship management service offered and any specificcharge should be transparent. It was in the nature of relationship management that there was no lending-specific element, unless some arbitrary split was made. Whether or not to charge fees specifically inrelation to lending was a matter for banks to decide.

8.291. A requirement for lower charges or (in some cases) no charges on current accounts for moneytransmission services would artificially constrain differentiation. There was a risk that such measureswould result in costs being recovered from charges on other services. This mitigated against transparencyand was therefore likely to be counter-productive.

8.292. External price controls on arrangement, renewal or security fees or any other additionalcharges would also risk artificially constraining differentiation.

8.293. Requirements concerning charges for clearing services and portable sort codes were withinthe proposed remit of the OFT and there was no need to take any separate action in the context of thisinquiry.

8.294. As to other regulatory options, any form of price control was likely to be counter-productiveto reduce the scope for flexibility and differentiation between service providers, and to render the marketless attractive to potential new entrants.

Possible behavioural remedies primarily to remove barriers to entry

8.295. On the possible availability of a database on SMEs, possibly including financial information,the BBA received a variety of opinions from its members. It had a general concern that any requirementon banks to provide information should be with customer consent or aggregated to preserve banking con-fidentiality. Any requirement would have to apply to all banks involved and it might be that too onerousan information obligation might act as a barrier to entry.

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8.296. The BBA supported steps to facilitate switching and would work with the industry andAPACS to develop minimum standards. It did not agree with the concept of banks having to bear all thecosts of switching, as this mechanism would be open to abuse by customers.

8.297. It was not clear what was envisaged by a portable credit history. This information was gener-ally already available through bank statements, which could be provided to third parties with the cus-tomer’s consent.

8.298. On limitation on bundling of services, a current account could act merely as a vehicle throughwhich deposits and loan repayments were made, but need not necessarily carry all the transmissionactivity of a business, which could be diverted to another provider. It was not clear that this arrangementwas significantly to the disadvantage of SMEs, nor that businesses would gain significantly from anyprohibition, as proposed. Rather than prohibit bundling arrangements of any kind, it suggested that busi-nesses be assured of free choice, and without being disadvantaged by not choosing a bundled product.This could be achieved through the proposed Business Banking Code.

8.299. On a possible requirement that banks inform customers of alternative suppliers of bankingservices, the BBA agreed that greater availability of comparative information on charges would assistcompetition and transparency in the market. The BBA was very shortly to launch product comparisontables. These were being produced with a high-profile independent partner and would enable SMEs tocompare products from over 30 providers. The tables would be freely available to the general public.

8.300. On improved transparency and comparability of charges and terms for the provision of bank-ing services, including transparency of risk assessment and rates of interest for loans, the BBA hadundertaken research into transparency of charges and interest, and the type of information required byuser participants. Its intention was to use these findings in the development of industry best practice.

8.301. It saw no reason why a bank should not provide a written response to a loan applicant,detailing why a loan had been refused.

8.302. On a requirement to publish information on the profitability of services to SMEs, the recentenquiries had highlighted the difficulty of identifying SME profitability without making arbitrary alloca-tions with the result that the information was difficult to interpret. Such information should be supplied,if at all, only to any monitoring authority.

8.303. On the ability of customers at no extra cost to use branches of other clearing banks or jointuse by clearing banks of branches (particularly in areas otherwise unserved), the BBA had plans to intro-duce pilot schemes to evaluate this concept, for both SMEs and personal customers in situations wherethe branch in question was the last one in a given locality. The pilot schemes would start this year.Particular issues to be evaluated included whether SME customers would use this service (research byBristol University showing that, on average, SMEs did not use the branch nearest to them, instead usingone about twice as far away), how to define an SME customer, how to deal with branch capacityconstraints, and how the costs involved should be shared among the parties involved. In the case of cashwithdrawal facilities beyond those covered by cheque cards, agency arrangements would be required.

8.304. The BBA was not sure how a requirement to offer cash collection services more widelywould increase competition. A blanket requirement could be a barrier to new entrants that chose to enterthis market in a small way or in one particular region or by providing niche services. The service mightbe of little benefit to businesses that did not generate large sums of cash. For other businesses, especiallythose receiving cheques, a better solution was for banks to encourage their customers to pay via BACS,which was usually quicker and cheaper and avoided the payee having to visit a branch to pay in. Forcash, other parties already offered secure collection and delivery services.

Possible behavioural remedies primarily to safeguard SMEs in their relationshipswith their banks

8.305. On a possible obligation to provide (in plain language) in a single document and explicitly theterms on which the services requested are to be and are provided to an individual customer, the BBAsupported initiatives designed to improve transparency and would continue to promote the need fortransparency at industry level.

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8.306. On a requirement for adequate minimum compensation for overcharging, for example oftreble the amount charged, the BBA would be happy to join discussions with the Financial Ombudsmanand user representatives regarding a structured mechanism for resolving disputes.

8.307. On a requirement relating to withdrawal of overdraft facilities, the BBA was not aware ofbanks withdrawing overdraft facilities on a significant scale, but accepted that the possibility of an over-draft being repayable on demand might be a concern to some businesses. There were initiatives withinthe industry to answer such concerns through provision of committed overdraft facilities. Nevertheless,banks must retain the right not to put stakeholders’ funds at undue risk and this should be borne in mindin suggesting remedies.

8.308. The hypothetical remedies statement had suggested provision of consumer-type safeguards inrelation to contract terms for loans to SMEs; regulation of the relationship between clearing banks andtheir customers including terms on which banking services are supplied and the marketing of such serv-ices and the introduction or extension of customer dispute arrangements and remedies available; or otherdirect remedies to the above points, for example prevention of unfair provisions including excessive orunnecessary security, guarantees, collateral and insurance.

8.309. The BBA commented that the expected return on a loan portfolio was the risk premiumreceivable over time (part of the interest charged) less the expected write-offs (expected in the statisticalsense—the likely percentage of loans which would default multiplied by the likely percentage loss ineach case of default). This return was highly geared according to the actual experience of write-off.Banks had found that taking security affected both the likelihood of default (the security owner provideda risk-averse influence on the borrower) and the likely loss in the event of default (by providing an alter-native source of funds). Many business propositions might not be viable without the lower risk premiumand consequently lower interest rate that resulted from the provision of security.

8.310. The BBA was currently undertaking work towards the launch of a Code of Conduct forBusiness Banking, including consultation with representatives of the business community, the BankingCode Standards Board and the Financial Ombudsman Service. Development of the Code was beingscheduled so as to take account of the findings and proposed remedies of this inquiry.

8.311. As far as EMBs were concerned, the BBA commented that it was unclear as to what particu-lar issues the CC was considering. The BBA recognized the importance of EMBs and an extensiveindependent research programme into financing and business support for EMBs was launched by theBBA in January 2000. The BBA research showed the importance of addressing issues to specificcommunities rather than to ethnic minorities as a single group. The research would be completed inJanuary 2002. The findings of the research were publicly available and would form the basis for policyplanning by banks and the Small Business Service thereafter.

A possible tax, licence fee or fund

8.312. It was difficult to see that any form of tax would promote competition to the extent that couldbe achieved through greater transparency and access. If competition was not effective at present, it wasfar more constructive to tackle the causes of the failure than to seek to punish those who were perceivedto have benefited. Real competition would result in a more vibrant economy whereas punitive taxationwould only generate avoiding action and act as a deterrent to new entrants.

8.313. The BBA believed that divestment of branches or accounts was more likely to be harmfulthan to adequately address issues of competition. It was difficult to see how this could be done withoutdisturbing some existing satisfactory relationships between banks and customers. To remove just theSME business from a branch might make that branch unviable, particularly in rural or socially deprivedlocations.

8.314. The BBA saw no need for divestment of banks’ factoring and invoice discounting subsidi-aries, as there were businesses that preferred to maintain their relationship with one financial servicesprovider and there could be advantages to the business in terms of sharing security within one financialgroup. However, it did see merit in banks being obliged to state that particular suppliers of these serviceswere subsidiaries of the bank, and that customers were free to choose to use an alternative supplier ifthey so wished.

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British Cheque Cashers Association

8.315. The British Cheque Cashers Association (BCCA) represents 350 companies that offercheque-cashing facilities through over 800 outlets in the UK. It told us that the industry had developed inthe last eight years to meet a market need that developed in the wake of the enactment of the Cheque Act1992. Nearly all the BCCA members fell within the definition of an SME.

8.316. In order to provide a service, BCCA members required access to a facility provided by aclearing bank. They also made extensive use of the normal money transmission system and credit facili-ties provided by banks. The majority relied on the services of UK banks, but a number also made use ofservices offered by banks whose headquarters are elsewhere in the EC.

8.317. The BCCA said that the market for the services sought by its members was highly competi-tive with respect to both service and price. The situation was much better in the UK than in a number ofother countries and it did not recognize the negative picture portrayed in parts of the Cruickshank report,although, like any service provider, its members wanted to see the services provided at a lower price andwould welcome greater certainty with regard to the long-term availability of services.

8.318. The BCCA re-emphasized a point made in its submission to the Cruickshank review, namelythat small businesses were vulnerable to changes in the rules governing the provision by banks of aservice, or the complete withdrawal of a service, where such services were based on industry levelagreements among the banks. BCCA members had twice been affected by changes in these rules, whichhad been made without prior consultation with interested parties and with inadequate notice to allowalternative systems to be put into place. In addition to such industry level changes, individual membershad been subject to sudden changes in the facilities made available to them by their clearing bank, or inthe terms on which such facilities were provided.

8.319. While the service provided by banks was considered generally to be good and the BCCAfully accepted the need for the banks to protect their own positions, there was a clear imbalance, not justin the information position between banks and the SMEs, but also in power.

8.320. European-based regulations concerning unfair terms in consumer contracts had done much toprotect individual consumers, as had the banking code in the UK. Banks had gone a long way to increasetheir sensitivity to the needs of their small corporate customers but the imbalance could still operate tothe detriment of small business customers. The BCCA believed attention should be paid to themechanisms by which changes in interbank rules and systems were introduced and the possibility of pro-viding safeguards to protect the interest of small corporate customers. Subsequently, indeed, it told us ithad been very pleased that a further proposal to change industry-level rules had been undertaken in amuch more consultative spirit by APACS, with the result it had had a full opportunity to input to the rulechange process.

British Retail Consortium

8.321. The British Retail Consortium (BRC) is the trade association of the retail industry represent-ing more than 90 per cent of the total retail trade in the UK, its retail membership covering all sectorsfrom the large multiples and department stores, through to the corner shop, from food and drink tofurniture and DIY, from town centre to rural and mail order. Its members occupy in excess of 290,000shops and provide employment for 2.9 million people. It told us that its response to the statement ofhypothetical remedies reflected the view of all nine BRC trade association members representing SMEs.The provision of banking services remained high on the list of concerns to SME members of the BRC.

8.322. The principal remedies supported by SME retailers were summarized as:

(a) greater transparency of cost structure, interest rate tariffs and ‘plain English’ contracts;

(b) removal of the banks’ ability to withdraw loan or overdraft facilities, without sufficient warningto allow alternative facilities to be arranged;

(c) unbundling of services, with clearly stated tariffs for each service maintained on a public register;

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(d) no impediment to new entrants wishing to provide banking services to SMEs;

(e) (b), (c) and (d) above together with other measures to assist in SMEs being able to switch banksfor key facilities more easily;

(f) charges for providing services should be directly related to the cost of providing the service; and

(g) the fallback interchange fee for payment cards should be abolished and in its place merchantsshould pay a flat (per transaction) fee for settlement and clearance only.

If the above measures did not result in a major reduction of charges/improvements on investment returnsfor the SME sector within two years, a central payments regulator should be invested with powers toregulate the returns made by banks on SME services and thereby facilitate cheaper tariffs, and improveinvestment rates.

8.323. Its detailed responses, referring to the paragraphs in the statement of hypothetical remedies atAppendix 2.3, were as follows.

8.324. Retailers strongly supported instant access/short-term deposit interest rates to be related tobase rate less a specific percentage (paragraph 8a(i)). BRC members were positive about set-off andsweep facility information being regularly updated and that there should not be any charge for suchfacilities (paragraph 8a(ii)).

8.325. Banks should be required to offer SMEs the choice of business or personal account chargesfor each type of service offered, together with an explanation of why the charges/interest rates weredifferent. For example, a business charge may be more expensive for cheque clearance because it wasmore rapid. The SME client might then make an informed choice. Each SME client would then have anaccount and facilities structure chosen from a menu of options (paragraph 11). As part of this remedy, therange of tariffs should include with and without relationship manager options, again with an exactdefinition of what a service manger would provide. For those SMEs considering an account without aservice manager, the cost of ad hoc advice should also be explained up front so that an informed choicemight be made (paragraph 12).

8.326. Retailers strongly supported lower charges on money transmission facilities. The chargeshould be related to the cost of providing the service and the risks taken (if any) (paragraph 15). Thereshould be no charge for overdraft renewal (paragraph 16).

8.327. All charges should be related to the cost of providing the service. Retailers supported theavailability of portable sort codes. The underlying principle was to remove barriers to new entrants(paragraph 17).

8.328. The BRC strongly supported the formation of an independent payments regulator endowedwith sufficient powers to regulate charges and returns and if necessary force recalcitrant clearing banksto reduce charges if they continued to make excessive profits (paragraph 18). The CC, as part of itsremedies for overcharging in SME banking services, should require the major clearing banks to providethe OFT with profitability information (paragraph 25). It should also publish a series of key performanceindicators for any organization providing banking services to SMEs (for example, interest rates ondeposit accounts should be within x per cent of base rate, all relevant tariffs publicly disclosed, etc). Ifthe payments regulator was installed in 2003, the clearing banks would have had at least two years to putin place measures to satisfy the key performance indicators. Any institution failing to comply would facethe full powers of the new regulator. The BRC had recommended that the new regulator should not onlymonitor the profitability of the players in the money transmission market but also have power to regulatereturns if greater transparency and new entrants did not result in lower prices/better returns on invest-ment. If the payments regulator took longer to set up than the estimated two years, the OFT under itsgeneral powers should regulate the market.

8.329. BRC members did not trust the banking industry to publish timely, clear, unambiguous tariffsto enhance competition (paragraphs 19 and 22). There should be a central register of prices/interest ratesmaintained or supervised by a government agency with clear rules for communication and definitions foreach category. Again, this could be part of the payments regulator’s brief. In the meantime the OFTunder its general powers might oversee this function.

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8.330. BRC members supported all the measures listed in 20(i) to 20(vi). In particular, security onmovement of loan and overdraft facilities was absolutely vital. No retailer would move account if thebusiness itself was jeopardized by the instantaneous removal of a loan or overdraft facility. The safe-guards for SMEs if they wished to move loan facilities should be spelt out in clear English. The BRCwelcomed the provision of consumer-type safeguards in relation to SME contract terms for loans.

8.331. The prohibition on any SME having to hold a current account as a condition for holding adeposit account or any type of loan other than an overdraft was strongly supported. This again wouldenhance the possibility of switching accounts (paragraph 21).

8.332. On use of branches of other banks, many retailers needed to deposit cash and cheques andreceive change frequently in the working week. If there were no branch available in the vicinity of theSME retailer, the ability to use other banks’ branches or post offices at reasonable cost again wouldfacilitate more switching of accounts (paragraph 27).

8.333. Retailers considered a single document, explaining in plain language the facilities a bankwould provide with tariffs and conditions simply stated, an absolute prerequisite to better service (para-graph 28). There should be a minimum compensation for overcharging of three times the amountcharged subject to a minimum absolute figure, for example £200 (paragraph 29).

8.334. The direct remedy suggested of preventing unfair/excessive security guarantees by taking alien on property, rather than the full value of a house, was welcomed (paragraph 31).

8.335. The BRC did not support a windfall tax on clearing banks should they continue to makeexcess profits unless the total value of the tax levied went into supplying services which SMEs wouldgain from (for example, provision of tariff information or collection of profit information by a regulator).Only if the Government could guarantee this use of funds would the BRC endorse this measure (para-graph 32).

8.336. Finally, retailers felt strongly that the setting of fallback interchange rates for bank paymentcards amounted to a form of industry price fixing. The BRC was concerned that no reference was madein the remedies paper to excessive charges banks made to SMEs for accepting bank payment cards: theBRC copied to us its evidence against Mastercard Europay UK Ltd, which had applied for exemptionfrom the powers of the Competition Act 1998 and which was currently under consideration by the OFT.

Business Link Isle of Wight Limited

8.337. Business Link Isle of Wight Limited (BLIWL), now part of Business Link Wessex, believedthat banks used credit scoring which often involved applying arbitrary rules. This was apparently to savetime and concentrate on the better accounts, but could thwart the Government’s intention to support‘honest insolvencies’. Risk strategies and charges based on such credit scoring did not seem to extend tothe lower level where funds might simply not be available at any cost.

8.338. Banks now often visited the customer at the banks’ insistence but then charged for such visits.Normally sales people visited customers for ‘goodwill’ purposes at no cost. This appeared to be amonopolistic action by the banks.

8.339. BLIWL felt that where banks gained EC fund support, the benefits seemed to be absorbedinto the banks’ fees, therefore little benefit seemed to be passed on to valid projects, especially at thelower end of the marketplace. The banks seemed to apply additional rules for the SFLGs, which couldsometimes invalidate it as an extremely useful tool in growing companies. BLIWL had worked effec-tively with the Small Firms department in Sheffield only to find that the banks might apply additionalrestrictions. This had been especially relevant where business angel investment was being put intogrowth companies.

8.340. With regard to bank funds transfers, BLIWL felt that the time taken to transfer between bankswas still unnecessarily high, taking substantial time in spite of the fact that cleared funds might be beingtransferred between banks. Three to five days to have access to cleared funds, in this electronic age, wasa great deal of time and could impact upon a small business where funds could often mean survival.

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Business Link Sussex Ltd

8.341. Business Link Sussex Ltd, a wholly-owned subsidiary of Sussex Enterprise (merger andacquisition activity), said that although the UK had always benefited from a broad and comprehensiverange of banking and financial institutions, mainstream banking services had traditionally and consis-tently been available through a number of the larger dominant institutions, the high street clearing banks.Merger and acquisition activity had seen these larger institutions grow significantly in a race to keeppace with the increasing globalization of commercial and financial activity and services. Despite themerger activity that had been seen, there were still four or five mainstream banking groups providingservices to the SME business sector and whose location and branch network were still predominantly intown and high street locations. The broad change here did not appear to be significant.

8.342. The increasing use of technology in all sizes of business had largely mirrored the pace andchanges in the nature and provision of banking services by the banking community and many businessesnow benefited from the speed and convenience that electronic and remote banking access and servicesnow offered. Some businesses had welcomed the convenience and efficiency offered by these servicesand had adapted accordingly to take advantage of them.

8.343. Technological developments had permitted lower entry cost levels for new businesses acrossmany industries and markets, which had seen a proliferation of new entrants and start-ups across allareas. Banking was no exception to this phenomenon and in fact electronic banking had seen a wholehost of new and successful entrants, particularly in the personal banking market. The demutualization ofother financial institutions had created further substantial banking-oriented institutions, a number ofwhich had offered services to businesses for some time.

8.344. Choice was naturally limited by the number of mainstream banks in the marketplace, but theincreasing activity of the demutualized institutions and other foreign banks in the UK and global marketshad widened choice and competition and was likely to continue to do so. However, the appetite of thesenew entrants to provide a broad range of services was naturally limited and it would not necessarily beattractive for them to choose to infiltrate all areas of the market, choosing only those that offered the bestreturns.

8.345. This suggested where the real strengths of the long-standing high street banks actually lay,which was in the historical networks and banking systems that they had traditionally operated and devel-oped over decades. It was only them that had the benefit of the cheque and clearing systems used bymost smaller businesses and the wide branch network with which customers had become so familiar andhad traditionally relied upon.

8.346. The real choice for many businesses was therefore restricted by this dominance of the main-stream banks but the costs associated with maintaining the networks and structures that provided theseservices were a barrier to other new entrants and wider competition. The mainstream banks must, there-fore, have a dominant position in the marketplace and would continue to justify the level of charges forthe associated services by the high costs of operation that stopped other competition from finding itattractive to enter the market.

The Campaign for Community Banking Services

8.347. The CCBS was particularly concerned about reduced access to counter services offeringmoney transmission and cash-handling aspects of banking services consequent upon the closure of over4,500 bank branches of the principal high street banks in the last decade, with more to come. Such ser-vices were effectively only available to small businesses through the five high street banking groups,which had 95 per cent of the market in accounts, and Girobank which enjoyed the monopoly of provid-ing banking services to businesses through the 18,000 post offices comprising the POCL network. In thecase of the high street banks, many services were inextricably linked to meeting the borrowing needs ofbusinesses, which restricted the use of Girobank for money transmission and cash services by theborrowing businesses to a ‘collection account’ role.

8.348. The CCBS told us that in hundreds of small communities the banking presence was nowlimited to one bank. Decisions to close branches had left a lot of communities without a bank. When thathappened, usually for national cost reduction reasons, other competitive banks did not seek to fill the

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void. (The CCBS was aware of only two cases in which another bank had opened following the closureof the previous sole bank.) When one bank in the community closed, others were likely to follow insuccession. None of the high street banks were now opening branches, thus leaving growing communi-ties without local access to banking services.

8.349. Business customers with one bank could make arrangements to use the counter facilities of amore conveniently situated competitor bank, but this facility was not widely known or encouraged andattracted usage fees generally higher than was the case for using another branch of the customer’saccount-holding bank. Small businesses travelled considerably further than their nearest bank in order topay in, evidencing, inter alia, unfamiliarity or prohibitive cost of the agency systems. For non-banks toestablish a collection point on behalf of banks not represented locally required a licence from the FSA ora contract with a licensed bank or banks. To be cost effective, in view of security and other issuesinvolved in cash handling, contractual arrangements would be necessary with several banks. Prior to theagreement of the BBA to a feasibility study of shared branches, there had been no indication of banksupport for such community-based collection points. The CCBS was, however, concerned about thelimited scale and scope of the BBA’s recently announced pilot scheme resulting from the study as ameasure of customer demand. The pilot would allow personal and small business customers to pay in,make withdrawals and exchange notes and coins through a competitor’s branch. This covered only tenlocations in England and Wales, with only a single branch within a 5-mile radius, hence excluding urban(and also Scottish) communities and including no non-bank outlets and no closed branches; there wasalso no plan to test the concept of a neutral branch, nor any involvement of consumer bodies in the pro-cess of selecting the pilot branches.

8.350. Girobank, however, could exclusively offer its business customers use of post office counters,an agreement with several years to run. Lloyds TSB was experimenting in one locality with usingGirobank as an intermediary, to allow its business customers to use post office counters. Lloyds TSB andthe other banks, reportedly, were endeavouring to break the POCL/Alliance & Leicester exclusive dealas using Girobank as an intermediary was cumbersome and expensive. The CCBS, however, contendedthat post office premises were unsuitable to act as banking agent for business customers (as well as indi-viduals and charities) of major high street banks, being small, unsecure and independently owned. IfPOCL did become agent for all banks, there would be a monopoly of banking transaction activity inthousands of communities with the power to set handling charges, ultimately paid for by the customer,without competition.

8.351. The CCBS therefore proposed the establishment of a nationwide network of multi-bank out-lets (community banks) to act as a neutral counter agent for all major banks in what would otherwise bebankless communities provided the local demand levels justified it. Competition could coexist with thisproposal as choice of bank would be made by the business customer solely on the fundamentals of thebanking service—price, product and relationship—with local access guaranteed; how the cost of thecommunity bank counter service would be passed on to the customer, if at all, would be at the discretionof the relationship bank.

Possible remedies

8.352. Commenting on the CC’s statement of hypothetical remedies, the CCBS said that its pro-posals for neutral multi-bank agencies presupposed a continuation of the SME market domination by themajor banking groups and the impossibility of a return to a regional/local banking structure as stillexisted in countries like Germany and Italy, for example, which enjoyed bank branch densities of two tothree times that of the UK.

8.353. On specific remedies (with reference to the paragraph numbers in Appendix 2.3), the CCBSsaid that there was no doubt that businesses did not switch from a closing bank to a remaining bank in acommunity partly because of the obstacles identified. Accordingly it supported (i) to (vi) of the possiblemeasures to improve switching, but had some reservations on (iv) in paragraph 20.

8.354. With reference to paragraph 21, a prohibition on any requirement to hold a current account asa condition of a loan or deposit, the CC’s suggested remedy would enable a business customer of aclosing bank to retain its fixed-term loan with that bank until maturity (to avoid penalty) while switchingits current account to a remaining bank in the community for reasons of convenience.

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8.355. On whether customers should be able at no extra cost to use branches of other banks, or thatthere should be just use of such banks, or a requirement to offer cash collection services more widely, theCCBS commented that the demand for local banking was not restricted to cash-based businesses butincluded businesses receiving a flow of cheque receipts and needing to get those into the bank clearingsystem without delays and without the perceived risks of the postal system. Mobile banks, with very highfixed costs and providing a very limited window of banking opportunity in each stopping place, wereunlikely to be viable except where acting as agent for several banks and in very remote areas. NatWestwithdrew from mobile banking some years ago and HSBC operated only four routes with old vehicles.The Scottish banks operated mobiles as a social service. The Post Office, in most larger banklesscommunities, was unsuited to the role of substitute bank.

8.356. The neutral community bank solution, advocated by the CCBS and validated recently by theBanking Centre of Loughborough University, would allow fixed costs to be shared between severalbanks and a wide variety of customers—personal, small business and voluntary bodies—while retainingor introducing competitive choice of relationship bank.

8.357. On a possible requirement that banks undertake to make branch facilities available on fair,reasonable and non-discriminatory terms to customers of other banks, the CCBS supported this remedy,which was particularly appropriate where the business account customer was receiving free or preferen-tial terms from its relationship bank, as a start-up business, for example. There would, however, be diffi-culties in urban areas where competing banks were represented in close proximity but local factors suchas parking/security risk could favour use of a particular bank and overload its premises and otherresources.

8.358. On balance it preferred the community bank approach, given that only in exceptional casesdid the closure of one local bank not lead eventually to the closure of all the remaining banks. In theunlikely event of one bank having special reasons for staying (for example, a significant corporaterelationship), there was no reason why a community bank should not be established alongside, serving asan access point for all other competing banks.

8.359. On a possible tax, licence fee or fund rather than attempting to windfall tax excess profitsfrom small business banking, the CCBS would prefer to see money transmission charges levied on busi-ness accounts to be more reflective of actual costs, and not, as seemed to be the case, subsidizing thepersonal market.

8.360. The CCBS, however, did favour a licence-based levy on all banking providers to fund a socialbanking foundation which would subsidize social banking initiatives including, inter alia, business start-ups as currently financed by a number of non-profit-making vehicles and also a community bank net-work to provide access, and therefore choice, in communities without banks or without a choice ofbanks.

8.361. The CCBS saw no case for possible structural remedies, which were probably impractical, butfurther concentration of branch-based banking provision was unwelcome in the present uncompetitive‘complex monopoly’ UK market for small business banking.

Factors & Discounters Association

8.362. The Factors & Discounters Association (FDA) represents approximately 35 companies with arange of ownership; these include UK clearing banks, through their factoring and discounting subsidi-aries, foreign banks, and independently-owned businesses. It wanted to ensure the best possible servicefor its clients, as that was good for the industry as a whole. Although it operated a code of conduct, itregarded itself as having a conciliatory function rather than as a regulatory body. A number of very smallfactoring companies operating on a very restricted geographical or industry-specific basis were notmembers of the FDA.

8.363. The range of products offered focused on receivables finance, which was broadly brokendown into factoring and invoice discounting, with a fast-growing yet small volume of other asset finance,commonly termed ‘asset-based finance’. The principal method of operation was by assignment ofclients’ invoices, in effect purchasing their clients’ invoices and sales ledger assets.

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8.364. Asset-based lending, which tended to involve larger clients, normally involved a receivablesfinance facility and larger exposure to an invoice discounting facility. The asset-based lenders wouldinclude a receivables finance facility that would include advances against a whole range of assets, or anyof the whole range of assets within a balance sheet. This was an area of the FDA’s operation that wasgrowing significantly.

8.365. There were two forms of factoring: recourse and non-recourse factoring. The recoursefacility, which represented most of the funding FDA members provided, involved purchasing the invoiceand advancing against it for a period of time. If it were unable to get payment it would not approve theinvoice for funding purposes and not lend against it. The risk remained with the client. The non-recoursefacility was where the factor agreed to take the invoice and once it was agreed would advance against it.The client was guaranteed the value of that invoice. The UK market was mostly recourse. The productarrived in the UK from the USA during the 1960s. It was a non-recourse product but over time itswitched back to recourse because of the flexibility of funding. A client was guaranteed a higher level offunding because factors did not impose credit limits on every account, which might restrict client fund-ing.

8.366. Non-recourse funding included being much more involved in the approval of individualclients. Different non-recourse factors operated in different ways. Some were entirely self-insured, asthey were big enough to be. They took a percentage for the insurance policy and then ran what waseffectively their own insurance fund. Most, however, would look for an independent insurer.

8.367. The difference between a disclosed invoice discounting facility and a disclosed factoringfacility depended simply on who ran the sales ledger and where the cash was paid to as it was collected.With a factoring facility the sales ledger management work, in the main, was carried out by the factor.With an invoice discounting facility the discounter would have to have the comfort that the client wasable to carry out the sales ledger work properly, and would collect the money and bank it to the accountof the invoice discounter. In a disclosed facility the relationship with the invoice discounter was noted onthe invoices; however, the money would be paid under that facility direct to the client who then banked itinto a trust account for the discount.

8.368. Invoice discounting was an undisclosed confidential facility. Those that offered the disclosedfacility would tend to offer it in situations where the finances of the prospect were less sound than theymight be, and less sound than they would require for an undisclosed facility. Similarly, the managementassessment did not need to be quite so sound for a disclosed facility. If the facility was disclosed it waseasier to take control of the ledger if there was a problem with the client as they knew of the factor’sexistence.

8.369. There was therefore a continuum of facilities that commenced with the fully disclosedfactoring facility through the disclosed invoice discounting facility to undisclosed invoice discounting.The larger facility tended to be undisclosed invoice discounting, the smaller facilities fully disclosedfactoring, but there was a large crossover. Invoice discounting was available to the smaller facilities(companies with a turnover of less than £0.75 million) but there were not many of them taking or able totake advantage of that: for invoice discounting facilities the FDA members would look for a financiallystronger client but, equally importantly, a client that was able to demonstrate that it had the managementexpertise to control the sales ledger and the banking. Invoice discounting would not normally be avail-able to start-ups.

8.370. The FDA said that the nature of the product and the service it offered was best suited to asituation where an invoice was raised and submitted to the client and the piece of work or productdelivery that it related to was complete. The most attractive piece of factoring or invoice discountingwould, for example, be the manufacture of engineering components. It was a fairly simple product forwhich, when delivered, there was a delivery note that was signed. That kind of business would typicallybe picked up by a client’s bank-owned factor. Export factoring was a major growth area, and was carriedout in two different ways. Some FDA members would use associate companies in other countries to lookafter and recover the debt. Others would complete all the work themselves from the UK using multi-lingual credit controllers.

8.371. A typical facility was drawn up on a 12-month contract with a three-month period of notice toterminate. However, there was normally a termination clause and a notice period clause, and there wassometimes confusion because the termination clause might be a one-year period. An annual contract was

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automatically renewed if trading continued. Usually in those situations the notice period would bebetween one and three months, but with a minimum income per year which was a renewable minimumincome which was set at around four to six months of anticipated income to be earned by the factor. Thatclause included only factoring commission income, not an element of anticipated income on fundsadvanced, which would be interest earned.

8.372. There was a growing acceptance during the 1980s that factoring was a genuine alternative forunder-capitalized, but potentially successful, businesses at the smaller end of the market. There was alsoevidence that it was not last-ditch finance, but that there were small businesses which, if provided withthis flexible finance, could grow and could see themselves through difficult times.

8.373. The FDA told us that the clearing banks, after the 1991 recession and with BoE encourage-ment, had driven factoring and invoice discounting as a principal tool of lending, and that was one of themajor motives behind the growth of the industry. There was almost a preference to factoring and invoicediscounting over overdrafts. This was a movement away from debenture lending into actual lendingagainst specific assets, which could be managed day to day and therefore have a more accurate feel as towhat was happening. The FDA also suggested that factoring or invoice discounting might sometimes besuitable as an alternative to term loans. However, it was essentially short-term working capital financeand fixed asset purchases might be more suitably financed through term loans and leasing, for example.

8.374. The FDA said that its emphasis would be on the sales ledger, which enabled it to fund suc-cessfully in situations where other types of finance could not. It collected the ledger more quickly as itmanaged it every day. This could reduce the number of debtor days in turn benefiting cash flow.

8.375. It believed the market was rapidly moving towards factoring and discounting becoming moreof a commodity and that there was less focus on service and more on IT and technology. There was alsoless interface with clients. The market was more competitive than three years ago with about threeentrants a year and rates had come down significantly. The FDA did not place itself in the commoditymarket. It sold on the service aspect and was a service business and that was how it differentiated itselffrom the clearing banks.

8.376. Independent operators emphasized the service aspect and had clients that wanted them. Theseclients might have been unattractive to the clearing banks because the level of sales ledger managementwas onerous relative to the scale of the client. This could arise for a number of reasons. There could be ahistory of business failure where an FDA business would take the view that with close hands-onmanagement a relationship could be maintained; a clearing bank might be less comfortable with thatsituation because the investment would have to be made in protective management. There were furtherexamples where, because of the emphasis on workload, an FDA business with its working practicesbecame more attractive on a cost basis to a prospective client. The FDA believed the majority of businessof the banks’ subsidiaries was generally generated in-house, but to a degree that varied between thebanks.

8.377. Charges for factoring and invoice discounting generally comprised a percentage of turnoverfee—typically between 1 and 2.5 per cent—and a margin over base, of some 2 to 2.25 per cent: a reduc-tion from 3 per cent within the last three years. The funding would be at an interest rate at least as attrac-tive as the comparable rate on an overdraft if that was the alternative, a similar business paying 3 to 4 percent over base on an overdraft: factoring was perceived to be a cheaper form of borrowing than an over-draft, and better value for money although the overall cost including commission was dearer. At thebottom end of the market, the clearing banks were driving prices down, with the possible effect ofsqueezing the independents out.

8.378. The typical non-bank subsidiary members also tended, however, to be financed by one ormore clearing banks—one rate quoted to us was base plus 1.4 per cent, a reduction from base plus2.5 per cent ten years ago; another base plus 1 per cent. There had been little difficulty acquiring funds.The banks also acted as clearers, for which transaction fees were charged. The FDA did not, however,think that this had given rise to competition issues.

8.379. A survey of one firm’s customers had shown that about 10 per cent had felt undue pressure touse the factoring or invoice discounting facilities of their clearing bank or the size of their residualfacility with the clearing bank could be reduced, although this was not a regular occurrence. Moreover,when quoting to take away business from a clearing bank, it might be necessary to obtain from that bank

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a waiver over the book debts, a request for which could flag up a factoring opportunity for the bank,which sometimes then prevaricated in providing the waiver while trying to win the business. Such pre-varication could cause serious problems for clients who might have little time to get a facility in place.Such instances had become more frequent, with a stronger focus by the clearing banks on marketing. TheFDA also believed that on occasion clearing banks would offer better deals if a portfolio of bankingservices were being acquired: but such situations could also arise from its own member firms, particu-larly to retain accounts.

8.380. Research also suggested that about two-thirds of SMEs referred to their bank managers foradvice on the financing options available, the balance seeking such advice from accountants, althoughsuch proportions might decline with increasing sophistication and use of new technologies by SMEs.Many entrepreneurs were focused on the trading requirements of their businesses, and would not givepriority to such financing issues, but the level of awareness of financing activities was increasing.

8.381. More transparency in the terms on which the clearing banks’ own facilities were providedwould help to offset the perception that banks could reduce facilities if independent suppliers were used.As to the possibility of banks being required to divest their factoring subsidiaries, the FDA would notwish to make such a suggestion. The impact would be dramatic, and in some respects possibly negativefrom the point of view of prospective clients, the ability to package in its acceptable sense being positivealthough also open to misuse. The clearing banks should also be credited with driving awareness offactoring and invoice discounters into the market. There might be merit in an understanding that waivers,where necessary, be granted in a set period of time, or explanation given if otherwise.

Federation of Small Businesses

8.382. The FSB, founded in 1974, is funded mostly by subscription from over 150,000 members. Itcarried out a major survey in the autumn of 1998, examining the nature of small business finance andbanking services to small firms. Responses were received from 15,819 small business owners. Responseswere analysed by Electoral Reform Ballot Services.

8.383. The survey showed that two-thirds of respondents (66 per cent) used a bank to finance theirbusiness and 65 per cent had an overdraft facility.

8.384. Results showed that one in three small businesses (32 per cent) had a term loan with theirbank, and that three-quarters of these (73 per cent) paid up to 5 per cent interest above base rate. Inaddition, 80 per cent of respondents who had a term loan with their bank also had an overdraft facility—leaving them particularly vulnerable with overdrafts repayable on demand. The bank often required acurrent account to be with the bank providing the loan, partly in order to be able to know a business’s fullfinancial position, and partly due to the practical problems of sharing security between different lenders.Although there had been a shift from use of overdrafts to fixed-term loans, the fixed-term loan was ser-viced out of the current account. Since interest and repayment of long-term loans was made from thecurrent account, demand for repayment or reduction of an overdraft could put a business at risk ofbecoming in difficulty on the long-term loan. If, moreover, the scheduled repayment of a loan could notbe made, that too became repayable on demand.

8.385. The FSB’s survey results showed almost three-quarters of SMEs dissatisfied with aspects ofbank charges. The FSB’s main concern was that the results suggested that banks were overchargingsmall firms when they could get away with it—one in three small business owners had applied for arefund from their bank and 96 per cent of these were granted their money back. Main categories of over-charging were on interest and arrangement fees; renewal fees were also widely resented by SMEs. Anumber of bodies provided services dealing with negotiations on banking matters, in particularovercharging, obtaining refunds in about 80 per cent of cases.

8.386. The majority of small businesses regarded what they were given by the bank as the standardprocedure or the standard tariff. Of the 47 per cent that had tried negotiating with their bank over theirloan, overdraft fees or interest rates, 72 per cent were successful in having their fees changed—or 33 percent of all respondents.

8.387. The survey also showed that 35 per cent of respondents had complained to their bank withinthe last 12 months. Unsatisfactory service was the main reason for the complaint, mentioned by 41 per

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cent (14 per cent of all respondents). The fact that surveys tended to show general satisfaction withbanking services, despite such a high level of complaint, showed that SMEs’ expectations of their bankswere being continuously lowered.

8.388. Using their own resources was the second most popular way that respondents funded theirbusiness, mentioned by 65 per cent, with other methods of financing the business a good way behind,hire purchase and leasing (31 per cent) and credit cards (24 per cent) being the next most common. Ofthose that had a term loan, 56 per cent had a fixed interest rate and 43 per cent had a variable rate. Ofthose that had their term loan secured, 83 per cent had freehold/leasehold property as security. One infive respondents were unaware of charges for notes and coin transactions.

8.389. One-third of survey respondents indicated that they had changed their principal bank at somepoint, but this was more common the shorter the time period they had been with their bank. The mainreason for changing bank was that charges were too high, cited by 72 per cent of these respondents.

8.390. The survey suggested that small business owners could still vote with their feet and walk outbut this was harder to do the longer a business had been with a bank. For example, there was the cost ofchanging any facilities, and the difficulty of changing standing orders and automatic transfers. Atendency to switch banks was also sometimes adversely interpreted by a business’s customers. Further-more, a business that was struggling would have a reduced choice of banks that were willing to take onthe account and assist in overcoming the practical difficulties of switching.

8.391. Although relations between banks and SMEs had improved, there was still room forimprovement. The two areas that caused major problems to businesses were being able to check theirinterest, in particular the calculations of the banks, and the time taken to get value for cheques after theyhad been deposited. There was no reason why value could not be given instantly, subject to recall if acheque bounced when presented. Currently, if a customer drew a cheque before an incoming cheque wascleared, resulting in an overdraft, he could be charged interest at a penal rate without the overdraft beingshown on the bank statement. If an overdraft limit expired, and there was a delay in extending it, thecomputer system would charge penal rate on the whole of the overdraft, unless manually overridden;penal rates could also be charged if there was a delay in entering temporary extensions to overdrafts.There were also recorded instances of deliberate overcharging outside the UK and anecdotal evidence ofsuch cases within the UK: but given the centralization of back-office functions, less scope than pre-viously for those to occur.

8.392. There was also a lack of clarity in terms, such as facility letters, some of which required legalinterpretation, at considerable cost to an SME. In the event of dispute, there was an imbalance ofresources available to banks and to SMEs in resolving such issues: the banks also had no incentiverapidly to resolve disputes since they continued to accumulate interest. There was also concern that whena business was in difficulty, the bank required the investigating accountant to become the receiver. In theevent of liquidation, the receivers had no obligation to sell at market prices.

8.393. The FSB recommended that the CC examined the various procedures by which small busi-nesses often found contracts changed simply at the bank manager’s whim, for example to require repay-ment on demand, generally when a business was in difficulty, or requiring closure of accounts, forexample when a bank decided to reduce its involvement in certain sectors. The alacrity with which bankmanagers were moved from their positions contributed to this because it obstructed the development of agood business relationship, confidence with the relationship manager being one of the most importantconsiderations to SMEs.

8.394. The FSB welcomed the CC’s investigation into credit card charges levied by banks onretailers. In particular, the charges levied for guarantees were a particular concern. As the Cruickshankreport noted, the upper estimate of credit and debit card fraud borne by card issuers was just under£75 million but UK issuers recovered some £300 million to provide the ‘guarantee’ for UK transactions.

8.395. The extent to which retailers were in practice guaranteed payment varied substantiallybetween retailers. For example, where transactions were not carried out face to face, it was very difficultfor the retailer to comply with the necessary conditions. Any such losses associated with a disputed orfraudulent transaction were usually borne by the retailer or merchant acquirer rather than the issuer.Retailers could reasonably argue that they were paying for a service they did not receive.

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8.396. The FSB also welcomed the CC’s investigation of the barriers to entry for other banks toaccess the small business market. The FSB had discussions with Wells Fargo some years ago with theview that the bank was to enter the market, but due to the four largest groups’ domination of the moneytransmission system Wells Fargo decided that the venture would not be worthwhile. The need for accessto clearing systems and for local relationships were main difficulties facing new entrants, including thevery labour-intensive requirement for managing overdrafts. Thus, recent entry had tended not to begeared to the whole spread of business but targeted at particular sectors with low current account activity.

8.397. Finally, the FSB had also been concerned with closure of local bank branches. Small busi-nesses affected by local closures suffered a loss of turnover of between 10 and 30 per cent as formerbank users shopped elsewhere and faced higher insurance premiums as more cash was held for longerperiods. Small businesses were themselves dependent on branches, 70 per cent visiting branches at leastonce a week: for retail and catering, almost all businesses would do so. Other effects of closures includedthe increase in time to carry out routine (often daily) banking and most people then paying by chequesfor small amounts, leading to an increase in bank charges. If a branch closed, SMEs tended to stay withthe bank, rather than switching to an alternative bank remaining in the local area, due in part to the diffi-culty in switching accounts but also to lack of confidence that the remaining bank would not also soondecide to close its local branch. Hence, if there were a number of banks in a particular locality, eachcould be unviable and successively closed, although one shared branch on its own would be viable: thesolution overwhelmingly favoured by small business was a shared branch.

Global Consulting (UK) Ltd

8.398. Global Consulting (UK) Ltd (Global Consulting) was concerned with the lack of competitionamong the high street banks when dealing with EMBs. Minority businesses paid a heavy price in termsof levels of interest, collateral and the inability to change banks or being able to shop around for genuinechoice.

8.399. Global Consulting told us that its long-term vision had been a platform of understanding andsupport for EMBs in the UK and the rest of Europe, to empower them to play an active and equitable partin shaping a common prosperous economy. It had consistently sought to shape and facilitate theenvironment for minority businesses in the UK.

8.400. While the banks had gone a long way in understanding the needs of ethnic minority com-munities, Global Consulting’s own research with business support agencies and minority business asso-ciations suggested the following deficiencies among most major high street banks:

(a) low levels of transparency;

(b) disproportionately high level of charges;

(c) contracts, mainly short-term borrowings for long-term needs;

(d) unusually high levels of security, often the family home for equitably geared lending;

(e) quality of advice was often mismatched due to lack of understanding customer needs;

(f) the bank’s penalizing the need for short-term cash-flow needs, not reflecting the short-termnature of many product cycles;

(g) lack of face-to-face banking in urban areas where there was a demographic majority of ethnicbusiness communities; and

(h) lack of non-executive directors from the minority communities.

8.401. The banks had consistently answered the need for advocacy by the minority communitieswith yet more research; however, consecutive researches carried out by banks had not yielded any newsolutions. The old problems were regurgitated as one research project followed another, which ‘boughttime’ while ignoring the actual needs of the minority communities. As a result, the entrepreneurial baseof our cities was being lost to the detriment of our economy in the long run.

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8.402. Global Consulting argued that an environment should be created to attract foreign banksactively to engage in lending to SMEs in this country. Genuine competition for an existing entrepreneurto shop with high street banks did not exist; the challenges facing the SMEs should be recognized andaddressed by creating a fiscal and monetary framework for competition. Best practice in minority bank-ing already existed in the USA. It was a question of whether there was political will to address this issueand commitment from bureaucrats to enshrine service to minorities in monitoring the banks. Commit-ment to the prosperity of ethnic business should be taken seriously as an essential economic benchmarkfor UK plc.

8.403. Commenting on the hypothetical remedies letter, Global Consulting urged the CC toexplicitly mention the distinct needs of the British EMB communities; their future should not be vestedon the goodwill of the banks alone but needed closer monitoring by the DTI and the Treasury as anintegrated regulation of the market.

Independent Banking Advisory Service

8.404. The Independent Banking Advisory Service believed that banks deliberately plundered busi-ness banking accounts for excessive interest using a ‘switch’ to a different and higher rate of charginginterest to overdrafts (the monthly managed rate) without a customer’s agreement or knowledge at thetime of the ‘switch’.

Institute of Directors

8.405. The Institute of Directors (IoD) is a non-political organization which represents over 54,000individual directors, the majority of whom are based in the UK. It provided us with copies of recentpolicy papers showing the result of recent surveys on Business Finance and Bank Finance; its mostrecent survey showed that 76 per cent of directors who were interviewed described their relationship withtheir bank as good, and 78 per cent did not believe it was difficult to get access to finance for their busi-ness. 86 per cent said that their business had never had a request for finance rejected by their bank; and62 per cent said that there was a good choice of bank finance.

8.406. The IoD said that the four largest banks had over 80 per cent of the small business market,which would not appear to be conducive to competition. However, although the small business marketwas dominated by just four banks, there was little evidence to suggest that this was because of collusionbetween the banks involved. There could be relatively few operators in this particular market because ofthe inherent risks involved in lending capital to small firms, and IoD members did not appear to believethere was a lack of competition in the small business market.

8.407. The IoD said that its members did not feel there was a lack of choice between the banks.40 per cent of its members in its 1999 survey (35 per cent in the most recent survey) had said that theyhad changed their bank in the past, as they believed they could get a better service from another bank.This indicated that there was at least a measure of competition between the banks in respect of the smallbusiness market.

8.408. The IoD believed that the recent developments in financial services could increase compe-tition in the small business market. The transformation of some of the UK’s building societies into bankshad been beneficial to the SMEs. Naturally, barriers to entry into the small firms market must be kept toa minimum. At the same time, competition between the banks in providing services to SMEs could bepromoted by ensuring transparency in the costs of services provided. In the absence of clear informationsmall firms could not make an informed choice about which bank to do business with. The IoD alsobelieved many businesses should seek to diminish their dependence on the banks by diversifying theirsources of finance. Enterprises that intended to grow should examine alternative forms of financebecause bank loans were unlikely to be able to meet their long-term financial needs.

Hypothetical remedies

8.409. The IoD also commented on the hypothetical remedies letter.

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Possible regulation of charges, terms, conditions or profits

8.410. On a requirement concerning rates of interest payable on deposit accounts and currentaccounts, the IoD believed that, broadly speaking, the rate of interest payable on instant access and short-term deposits should be left to the banks to determine. Rather than requiring the existing banks to pay aparticular level of interest by government decree or regulatory order, it would be preferable to encouragemore banks to compete in the SME market. Ideally, the competitive process should lead some banks topay better rates of interest in order for them to attract more customers.

8.411. Requiring the banks regularly to notify set-off and sweep facilities would be welcome. How-ever, it would be unreasonable to prohibit the banks from charging set-off and sweep facilities, since itdid cost the banks to provide this service.

8.412. The IoD was not convinced that there was a need for imposing constraints on charges for thesupply of other banking services and loan interest: it would be preferable to encourage more banks toenter the SME market because the greater competition that this would entail should help to keep chargesdown.

8.413. A prohibition on discrimination of charges between personal and business accounts and/orbetween personal and SME customers was not an issue for the majority of IoD members.

8.414. Naturally SMEs would welcome lower charges or (in some cases) no charges on currentaccounts for money transmission services. Ideally this should be achieved in the process of greatercompetition between the banks for the custom of SMEs. In other words, banks might offer reducedcharges for money transmission services to SMEs as part of a campaign to persuade small businesses toswitch to them. Increased competition in this area was probably dependent upon a greater number ofbanks operating in the SME market.

8.415. Hopefully arrangement, renewal or security fees or any other additional charges might fall asa corollary of greater competition between the banks in the future.

8.416. The introduction of portable sort codes sounded an attractive idea: portable telephonenumbers had helped to promote competition in the mobile phone market and portable sort codes couldassist in furthering competition in the SME banking market.

8.417. The IoD believed that the idea that the banks should be subject to a price control regime wasquite extraordinary. The banks were not providing a basic public service, such as the provision of wateror the supply of electricity. Accordingly, they should not be subject to the kind of price control systemthat the public utilities operated under.

8.418. Although the supply of banking services to the SME sector was at present concentratedamong just four banks, it would be preferable to encourage the emergence of more suppliers of bankingservices to SMEs rather than introducing a system of price controls on the present participants in themarket. Indeed, the imposition of price controls in the form, for example, of a cap on bank lending feesand a restriction on annual price changes in the manner of an RPI–X formula could have the undesirableconsequence of actually deterring new entrants from the market. New players would only attempt toenter the SME banking market if they believed they could make a profit. If the ability of the banks tomake a profit in the supply of services to SMEs was restricted by government decree, it was difficult tobelieve that there would be a stampede of new banks into this particular market.

8.419. Moreover, introducing price controls on the banks could have the unintended result of redu-cing their profitability to such an extent that they became targets for foreign takeover bids. This, after all,had been the case with certain companies in the water and electricity industries. Although the IoDwelcomed foreign operators in many UK markets, it was regrettable when indigenous operators werevirtually eliminated. It would be unfortunate if overseas operators were to be predominant in the pro-vision of banking services to SMEs too.

Possible behavioural remedies to reduce or remove the barriers to entry

8.420. The IoD was not in a position to judge whether sufficient information was available to newentrants to the SME market on the financial performance of small businesses.

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8.421. On assistance to switching, although research published by the IoD indicated that some IoDmembers were prepared to switch from one bank to another, it recognized that many SMEs were prob-ably reluctant to change their banks. For many small firms, this could be because they were happy withthe quality of service that they received from their existing bank or because they preferred to stick withthe devil that they knew. However, other SMEs might be deterred from switching banks for the simplereason that it was just too much hassle.

8.422. As a matter of principle it should be made as easy as possible for a customer to switch fromone bank to another. The hypothetical remedies mentioned by the CC to assist SMEs in changing theirbanks were attractive. The proposal that banks should be required to meet a minimum industry standardon their practices in respect of customers who wished to switch accounts, to be approved by the OFT,seemed reasonable. Similarly, in theory, it did not seem unreasonable to ask the banks to develop port-able account numbers to assist the transfer of accounts between banks. Nor did it appear unreasonable forthe banks to apply a specific timetable for the completion of switching and for penalties to be incurred ifthey failed to comply with this timetable or if they made errors in the process of arranging for a customerto change his/her bank. The development of a portable credit history for SMEs, to enhance their ability toswitch banks, would also be welcome. Naturally, it would be popular if banks were to bear the cost ofswitching accounts, rather than the SMEs in question.

8.423. On limitation on bundling of banking services, in principle, it seemed unreasonable to requireSMEs to hold a current account with a bank as a condition for holding a deposit account or taking out aloan, other than an overdraft. If such a practice were to be prohibited, a clearing bank should be free torequest from an SME, with a loan but no current account with that bank, copies of current account state-ments with another bank.

8.424. On the suggestion that banks inform customers of alternative suppliers of banking services,switching from one bank to another would certainly be made easier if SMEs had reliable informationabout the different charges levied by the banks. Accordingly, the idea that the clearing banks should berequired on a regular basis to provide specified information on main money transmission charges andcurrent and deposit account interest rates to an institution such as the BBA or the FSA, which would thencompile the data into an overall list for comparative purposes, would be welcome. As many banks aspossible should be required to provide such information so that SMEs were in a better position to makeinformed choices.

8.425. On improved transparency and comparability of charges and terms for the provision of bank-ing services, including transparency of risk assessment and rates of interest for loans, it would probablyalso be useful for SMEs if the banks were required to provide information about loan interest rates,charges and terms that they made to an institution such as the BBA or the FSA, which could thencompile the information into an overall list for comparative purposes.

8.426. Although the banks were not obliged to provide a loan to a customer, it would be helpful for abusiness that had had a request for finance turned down to know why. It could then take remedial actionto improve the likelihood that a future request for finance would be more successful.

8.427. It might be useful for customers to have the option of requesting a more detailed billingstatement from a bank. However, just as telephone providers charged customers who requested anitemized billing form, so the banks should be allowed to charge their SME customers who asked for amore detailed billing statement.

8.428. On a requirement to publish information on the profitability of services to SMEs, informationof this kind did not seem to be particularly imperative.

8.429. On the suggestion that customers should be able at no extra cost to use branches of otherclearing banks or of joint use by clearing banks of branches (particularly in areas otherwise unserved), ora requirement to offer cash collection services more widely, both proposals had a certain amount ofattraction. However, the danger existed that if either of these options were to be implemented, newentrants to the SME banking market would have no incentive to establish their own network becausethey could simply free ride on the services of the existing banks. Indeed, some of the existing banksmight also take the view that there was little advantage for them to maintain their network if they couldmake use of other banks’ branch networks. So the effect of these proposals could be a further fall in thenumber of bank branches. This would be regrettable.

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Possible behavioural remedies primarily to safeguard SMEs in their relationships with theirbanks

8.430. The banks should as a matter of course provide (in plain language) in a single document andexplicitly the terms on which the services requested were to be and were provided to an individual cus-tomer.

8.431. On a requirement for adequate minimum compensation for overcharging, for example oftreble the amount charged, IoD members did not appear to consider overcharging by the banks as one oftheir principal concerns. Arguably, it should be left to individual banks to offer compensation for over-charging. In this way, competition between the banks should be encouraged.

8.432. For similar reasons, the banks should not be required to offer an overdraft facility guaranteedfor minimum periods. If competition between the banks was to flourish, there must be room for differen-tiation and experimentation in the provision of services.

8.433. In view of the fact that dissatisfied business customers could already complain to the BankingOmbudsman, it was not obvious that measures such as widening the role of a regulatory or competitionauthority to oversee the activities of the banks was necessary.

8.434. There was no convincing case for preventing banks from demanding a certain level of collat-eral or security. The evidence to suggest that banks demanded unreasonable security, collateral orinsurance in return for finance did not appear to be overwhelming. The IoD research did not convin-cingly indicate that this was a problem for the majority of SMEs.

A possible tax, licence fee or fund

8.435. The suggestion that a windfall tax should be levied on the banks if profits were decreed to betoo high would be quite wrong. Generally speaking, organizations that legally made large profits shouldbe praised, not vilified. Profit-making organizations were able to reward shareholders and employees,create jobs and contribute indirectly to the provision of public services through taxation.

8.436. Moreover, a free market economy required organizations to be able to make significant prof-its in order to function effectively. This was because high profits provided a signal and an incentive toentrepreneurs and businesses about which areas of the economy were worth operating in. With respect tothe provision of banking services to SMEs, the fact that the four largest groups were able to reap profitswas surely one of the factors behind the interest of other banks such as Alliance & Leicester and AbbeyNational to enter this particular market. However, a windfall tax on bank profits could deter new entrantsinto the supply of banking services to SMEs. New banks would have no incentive to supply bankingservices to SMEs because of the danger that the Government might inflict a tax on their profits wheneverit arbitrarily decided that their profits were too high.

8.437. Additionally, the banks, like other businesses, needed the Government to establish a stablesystem of taxation so that they were able to make medium- to long-term business decisions with relativeconfidence. The imposition of an arbitrary windfall tax would inhibit such decision-making. More gener-ally, a windfall tax on what might be deemed to be high bank profits would send out a wider signal tooverseas investors that the UK Government was hostile to profit-making and to business.

8.438. Furthermore, it was difficult to see how a windfall tax on bank profits would actually be ofbenefit to SMEs. As already mentioned, the effect of a windfall tax might be to stymie competition in thesupply of banking services to SMEs because it could act as a disincentive to new entrants in the market.Although it had been suggested that the money raised via a windfall tax could be used to help meet thefinancial needs of SMEs, the IoD’s research suggested that for most SMEs access to finance was not amajor problem. It would be useful to disseminate information on comparative prices, but a windfall taxwas not necessary to finance this activity. Either the banks themselves should be persuaded to providesuch information, or the Small Business Service could undertake to perform this activity.

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Structural remedies

8.439. Bearing in mind the relatively favourable outlook that a majority of IoD members had withregard to the banks, the IoD did not see the case for obliging some banks to divest some of their branchesto other banks in order to promote competition. Besides, such an action would be very disruptive to cus-tomers and, as a corollary, probably very unpopular. For similar reasons, it did not see a strong case forrequiring certain banks to divest themselves of businesses and accounts in certain areas, or the need forimposing a cap on local market shares.

8.440. Consequently, if the CC concluded that the supply of banking services by the clearing banksto SMEs did operate against the public interest, it would be preferable if some of the behaviouralremedies to reduce or remove barriers to entry that were suggested by the CC were introduced.

National Farmers’ Union

8.441. The NFU told us that it had general concerns about the imposition of arrangement and otherfees that might even be recharged annually and which added significantly to the costs of borrowings andshould more properly be reflected in the interest charged. Where documents (such as insurance policiesor deeds) were held as security for loans it was again usual to find not insubstantial charges being madefor the retention of those documents. These again appeared to be additional charges made simply to boostprofits. There appeared to be a plethora of additional charges for various items added to loan facilities.The cost to the customer of utilizing the product (the loan) should be the interest charge and theincidental costs of supplying the product should be borne by the supplier (the bank), as was the case inalmost every other field of business.

The Forum of Private Business

8.442. The Forum of Private Business (the Forum) is a non-profit-seeking organization limited byguarantee, with 25,000 members. Its mission was to influence laws and policies that affected privatebusiness and provide members with the support they needed to grow profitably.

8.443. The Forum had conducted banking research since 1986, the longest running and the largest ofits type in the world. It conducted both written and telephone response surveys. Its surveys includedrandomly questioning bank customers, not just members of the Forum. It stressed to us the diversity ofsmall businesses, for example between generalist businesses and those able to use more specialist staff.

8.444. Banking currently rated fourth out of 27 issues of concern to its members. Although the sur-veys showed that there had been a gradual improvement in perception over time, there was now a greatervariation between the banks in their performance. The Forum pointed out the dependence of small busi-nesses on the financing support and the money transmission process provided by the banks. Banksdominated the market because they could determine the nature of the relationship with the customer. Itbelieved that such dependence on dominant providers could lead to the acceptance of what could beuncompetitive practice. The Forum identified four major problems with this: transaction charges, marginwhen borrowing, collateral when borrowing and availability of credit when borrowing.

Transaction charges

8.445. Since the banks owned the money transaction system, there was no competition, and notransparent link to debt balance or interest. In this way banks could dominate an individual customer.The banks dominated the SME market by incentive payments, locking SMEs in by selling them either alife policy, insurance policy or a mortgage. These were difficult to unravel when changing banks.

8.446. The Forum said that banks had been overcharging SMEs for the last 14 years. If such chargeswere reduced more businesses would borrow.

8.447. The Forum explained that although it was now possible for its members to go to their banksand get a menu of charges, previously there had been confusion over banking charges. The main problemidentified by the Forum’s members was the existence of money transaction charges. Members had

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experienced the discovery of charges only when they examined their bank statement. Memberscomplained because they could not see that the bank had incurred cost to warrant a charge for a particu-lar service, and, secondly, the customer believed that he had received no benefit.

8.448. From its research the Forum had found that although 65 per cent of its members consideredchanging banks, primarily because of the level of charges, only 5 per cent did so each year. One reasonwas out of loyalty and the second was because it was a nightmare to do so. It was incredibly difficult tochange and there was no guarantee that the next bank was going to be any different. However, the mostimportant reason why people changed banks was because they were fed up with charges.

Collateral when borrowing

8.449. Many SMEs had experienced a problem with collateral, or security. In order for an SME toborrow a certain amount of money, the bank required at least the same amount of security, and in mostcases significantly more.

Margin when borrowing

8.450. The Forum explained that the interest rate was not transparently linked to risk. Why shouldone customer pay more in margin than another customer? Logically the higher the risk, the more youshould pay, but if one looked at margins, variations were very small. Not many people paid more than6 per cent over base, but in the true spectrum of business risk it imagined that there would be some busi-nesses that were a lot more risky than other businesses, and, therefore, the bank should be transparent incharging based on risk. The Forum had itself proposed a two-page self-assessment risk form which it hadproduced that would allow SMEs to appreciate the reasons for the risk ratings by the banks, but the bankshad not followed up this proposal.

Availability of credit

8.451. The Forum noted that banks never gave reasons for not providing an SME with a loan.

The 2000 survey

8.452. The Forum gave further evidence to the CC following the publication of its 2000 survey.

8.453. In this survey, a majority of its members said that the performance of all banks had fallen.The four most important issues to members were reliability, efficiency, cost and speed of decision; mainconcerns were the downturn in quality; and fear of termination of overdrafts.

8.454. The overall comment from the Forum’s members concerning provision and information onproducts was a positive one, these being increasingly available using new technology, and givingmembers greater ownership: members could get all the information they wanted quickly. However,members also believed that in personal interaction—receiving that information and acting upon it—therewas segmentation and a sense of disengagement from the bank.

8.455. One major issue was the length of time needed to receive a decision from the bank. The speedof provision of information had increased, but the speed of decision had remained the same. The Forumwanted the speed of decision to be the same as the speed of information. However, it knew from itsresearch that the SME view of staff quality had decreased. Banks’ computers and call centres hadincreased the quantity and speed of information for small businesses, but there was insufficient quality ofstaff to action that improved information.

8.456. The Forum said that banks had to manage the change from making their product more effec-tive and making the people more effective. In that process banks had to satisfy the customers and share-holder values. The Forum did not want banks not to be profitable; it just wanted them to do a good job.

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Banks had invested in the product side of their business, but computers and call centres were not able tomake decisions—these had to be made by people. Providing this service was becoming more difficultbecause of the reductions in staff levels and lower standards of training.

8.457. The Forum said, based on the material given in its survey, that the banks had a segmentedservice, and businesses with a turnover of below £1 million were not provided with the same quality ofservice as businesses with turnover of £1 million plus.

8.458. In looking at bank staff and quality of service, the Forum’s 1998 survey showed that qualityof service by bank staff was good, but the speed of information was slower, although it could be arguedthat the reaction time provided a period for management consideration and decision. In the 2000 survey,the speed of information had become a lot faster, but the quality of staff had become worse, so althoughthe information was available it could not be actioned.

8.459. The Forum believed speed of information was vital to any small business. It was one of theirstrengths, together with versatility, flexibility and, most importantly, their ability to react quickly to themarket. Without this quick reaction to the market, they would not survive. Part of this quick reactionprocess was being able to get decisions from the bank, as a great deal of the funding was dependent onthe bank.

8.460. In the past, the small business would have a relationship with the local bank manager, whounderstood the local economy, and was able to deal with questions and be supportive of their business.Today, bank staff did not have that facility, or the training or ability to deal with the situation. Theypassed the question to the superior, which compounded the immediate problem rather than resolve it.Local knowledge was an extremely important issue for the small business and the Forum questioned theconcept that there had to be a bank central office. It would not matter where a person was based so longas he was able to understand the locality and had the ability to go to those businesses located within it.This would mean that it was unnecessary for businesses to have to go to the bank, as the bank wouldcome to them.

8.461. The Forum said that its 2000 survey had showed there were indications that more SMEs hadconsidered changing banks. However, SMEs were very loyal to their banks and they did not changeeasily, in part due to the shortage of the time to do so.

8.462. The Forum believed the banks were wrong to push SMEs out of overdrafts and into loans. Aloan involved regular monthly payments but, as long as repayments were being made, the bank did notknow what the money was going on or what was happening with the remainder of the money, and wasunlikely to find out until the loan term was over. An overdraft fluctuated and the bank could see thechanges. A loan tended to split the bank/customer relationship apart, whereas an overdraft drove therelationship together. Overdrafts were also working capital, not for acquiring assets.

8.463. The Forum said that there was an acceptance that the individual branch was reducing inimportance, but the importance of someone with knowledge of local conditions was increasing. Therehad been an enormous increase in computerization and use of call centres, and the back office of a bankbranch was non-existent. However, there were concerns that loss of branches meant the loss of secureplaces to deposit cash and cheques.

8.464. The Forum believed the banks would not be able to maintain the level of service through theirbranches as had been provided in the past. Developments in technology had made it much easier toaccess the banks through the Internet, and in time all customers would be able to access all information,including bank statements, in this way.

Comments on Issues Letter

8.465. The Forum also provided us with some further comments on the Issues Letter.

The monopoly situation

8.466. First, it believed there was a scale monopoly in money transmission because there was onlyone source of supply for the principal clearing banks, namely the service run by APACS. Such a

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monopoly must exist to maintain a clearance period of a minimum of three days, where there wasevidence that clearing systems could operate with a one-day period. On other aspects of the monopolysituations, the Forum believed it would be very surprising if the banks were prepared to provide an over-draft if there were no current account or deposit account or in some cases life cover: the suppliercontrolled the lending decisions which the customer had to accept. The practice of association of bothoverdraft and loans with the requirement of provision of another form of account did in its view prevent,restrict or distort competition. The same constraints applied to availability of loans, and to the banks’involvement in the Government’s loan guarantee scheme: the bank made the decision as to whether ornot the application qualified for the loan under the terms of the Government’s loan guarantee scheme,and the customer had to accept that, as it was almost impossible to go to another bank without changingcurrent and deposit accounts. Similarly on price, the evidence suggested that there were severe limita-tions on the range of margins applied by the banks and little evidence of the relationship of those marginsto risk.

8.467. The Forum believed there was a lack of price competition. SMEs could and did negotiatelower prices than were advertised publicly: the process was generally motivated by the knowledge thatthe bank wished to retain SMEs as customers. This flexibility demonstrated cross-subsidy or overpricing.It also suggested that the customer could not effectively compare the value for money which could beachieved from other suppliers: if there were a fully transparent price structure with the quantity discountsfor SMEs it would be possible to judge and compare prices and value for money. The flat rate charge permonth for interest and transactions, irrespective of the customer demand, was the worst example of thebanks’ apparent monopolist charging, as was the widely publicized free banking for premium customers.If there was strong competition, there should be greater evidence of a spread of prices for more cus-tomers, but margins were too narrow, normally 2 to 4 per cent; if these margins were truly set to coverthe losses on individual accounts at that level of risk, margins would need to be as high as 10 to 12 percent.

8.468. The Forum also believed there was significant evidence of differentiation between personaland business accounts, even at the level of a single individual who traded as a business rather than apersonal customer: this must be totally wrong in a fully competitive market and once again proved cross-subsidy.

8.469. Anecdotal evidence suggested that a significant majority of SMEs were totally unaware ofset-off, swap or sweep facilities: the failure to disclose such opportunities might well restrict or distortcompetition, but also applied to other facilities such as BACS. Although the Forum had on two separateoccasions in the last ten years conducted detailed pilots with the banks in order to educate SME cus-tomers more effectively in their understanding of bank practices (the business risk assessment form andbank finance review document), no bank had accepted them officially as a principle.

8.470. The Forum also believed from evidence in its bank report 2000 that banks used their cus-tomers’ fear of withdrawal of services (for example, termination of overdraft) to encourage the acqui-sition of more than one service. This linking of services might not necessarily be as a result of conditionsovertly imposed by the supplier, but could be as a result of deduction by the customer that maintenanceof supply was conditional on receiving the totality of the service. SMEs had in turn been inhibited fromswitching by the element of fear imposed, and also because there was no real understanding by the cus-tomers of risk assessment or risk-related margin. Thus businesses did not know the value of risk assess-ment and there could be little competition if a customer was unable to compare the terms of differentbanks.

Competition

8.471. On the effectiveness of competition, the Forum felt this appeared to diminish significantly inrelation to size and financial vulnerability of businesses: ie for the smallest businesses there was greaterdifficulty in obtaining an alternative supply of individual services. As to price negotiation, the Forumstrongly suggested that, both from its anecdotal evidence and comment in surveys and from its memberinformation services, the banks had reduced service prices to retain accounts.

8.472. As to the low levels of switching, the significant constraints on actual switching werebundling, the cost penalties of switching, and a lack of knowledge of the new supplier. The substantialdifference evident in respondents to the Forum survey between intent to switch and actual switching alsostrongly suggested that potential difficulties and disadvantages were anticipated for the actual process.

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This must include anticipation of delays, redemption penalties, fear of practical difficulty, as well asinertia that might not necessarily be attributable to a lack of price sensitivity but also to problems inaccessing sufficient independent data on switching advantages. The Forum had considerable anecdotalevidence of the difficulties of disentangling the totality of services provided when switching bank wasundertaken. A business needed immediate and seamless transfer of services such as direct debit pay-ment/receipt and standing order processing; where delays were evident, whether deliberate or uninten-tional, the creditability of a business could be irretrievably damaged. The fear of this risk might oftenmitigate against a decision to change banks. The view that long-term relationships were advantageouswas also a traditional one and the relative novelty of the changes brought about by new technology wereprobably still not sufficiently understood to impact positively on a traditional concept. All theseconstraints must contribute to limitation of the propensity to switch banks and should be regarded as afactor in this reduction of effective competition.

8.473. The levels of collateral were based on substantially higher ratios in the UK than the USA,questioning the need in the UK to request such high levels of collateral against borrowing. Where theselevels were required, it must follow that SMEs would be inhibited from acquiring banking services thatdepended upon collateral from other sources, as available collateral was likely to be more limited.

8.474. As to transparency, the Forum’s evidence had consistently shown that lack of understandingby SMEs of bank charges was manifest in their difficulties in making direct comparisons.

8.475. As to number of competitors, while it was evident that there were a number of suppliers forindividual banking services, the majority of SMEs could only obtain the full range of services theysought from the clearing banks. Thus choice was limited, and where conditional lending was offered(loans being granted only on condition of acceptance of other bank services such as current accounts)there was inhibition in terms of possible alternative suppliers. Such bundling was frequently perceived bySMEs to be a tacit condition of borrowing.

Relations with customers

8.476. As to relations with customers, the Forum believed that for some sectors of SMEs the closureof bank branches had been to their detriment, particularly those operating cash businesses. There wasconcern that the question of economical and convenient paying-in activity be resolved for these SMEs.

8.477. There was clearly an imbalance of power between clearing banks and SMEs with few fullcontracts between them beyond a letter of intent, which had little legal force as far as SMEs wereconcerned. There was little evidence that SMEs had any redress for actions taken by the banks whereshort-term cash-flow problems had become evident and the banks appeared to be able to operate sub-stantial discretionary powers.

8.478. Significant anecdotal evidence suggested that banks’ procedures when resorting to securityhad been overbearing and excessive. A high level of collateral had been required (for example, a lien onpersonal property) and banks had acted to repossess the entire property rather than accepting ownershipof part of the collateral that related to the default amount. The appointment of liquidators was generallyat the request of the bank; this was often preceded by the appointment of an investigating accountant atthe cost of the customer—that accountant was then often used as the receiver if the bank reduced its sup-port. The customer might in some cases be allowed to see the report, but it was perceived to be used bythe bank to determine the best day to withdraw the loan or overdraft facility. Recourse to law and theFinancial Ombudsman did not always provide an appropriate facility to small SMEs in dispute: anecdotalinformation suggested a critical delay in action where disputes had been deferred. The Ombudsmanservice should also cover more businesses than was the case under the present limit of £1 million turn-over.

Possible remedies

8.479. The Forum believed that the facility letter, the charters, and the ‘Principles of Bank andBusiness Working Together’ ensured a one-sided domination of the relationship by the bank. It believedthat the banks should provide a contract for the whole of the SME bank relationship in order to bring the

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issues of margin, collateral, penalties etc into one accurately agreed and legally enforceable contract.This would also overcome the problems caused when bank managers changed. Banks should give anindication of what they would do if businesses got into difficulty—for example, not to withdraw supportwithout due warning. No bank was prepared to accept this suggestion.

8.480. The Forum believed that banks should be made to break down their profitability, and themarket should be opened up to allow competitors to provide the more profitable services. Improvementin the working relationship between banks and their customers would lead to increasing jobs andincreasing wealth. The Forum believed that both banks and their customers needed to develop participa-tive relationships: it had found that ethnic minorities had particular difficulties in establishing suchrelations with banks.

8.481. The Forum also favoured the following additional remedies:

(a) All cross-subsidy between the small business sector and big business sector and personal cus-tomers should be eliminated.

(b) The risk to margin relationship should be based on transparent measurement of risk with widerbands of interest.

(c) SMEs should pay according to the quantity and quality they needed rather than package servicesand price set by the banks based on their size and profitability.

(d) Money transmission charges and all other prices should be transparent with fixed quantity dis-counts, interest on current accounts paid, interest on deposit paid, no free banking to personalcustomers or new business start-ups. The BoE should publish transaction charges, deposit ratesand the borrowing costs per bank, per quarter. All this should be duplicated by another supplierto compete for the current money transmission APACS system.

(e) Changing banks should be like changing lanes on a motorway: the banks should agree a docu-ment for the small business owner that was provided by the existing bank; a documented list ofall the elements of change should be checked for the customer; the new bank should have a copyof the form and should check with the customer that all the issues had indeed been changed.

(f) There should be a fixed charge for changing banks to reduce any possibility of cross-subsidy.

(g) If there were difficulties in areas where there was an outstanding loan, the bank should agree totake on any existing loans without applying the LIBOR conditions of termination of loan. Theaccount should not change until a new supplier had signed the document to provide the evidencethat details were complete.

(h) Collateral should be transportable. The maximum collateral that could be taken for a loan shouldbe 1:1 compared with a current average of 2.3:1. If the value of security, such as a house,exceeded the value of a loan, the bank should take part of the asset of the house leaving the restof the asset available for the business owner to negotiate other deals.

(i) As to availability of finance, all lending should be based on transparent risk assessment, withclear and practical reasons based on risk assessment for any loans turned down, the right ofappeal for the customer to another part of the bank or to have the document taken to anotherbank.

(j) There was also a good case for dividing activities of the current high street banks into three mainsectors: monetary provision and debt finance sector; asset finance service; and special services.

Finance & Leasing Association

8.482. The FLA said that asset finance had grown steadily as a source of business finance. There hadalso been increasing growth in services in addition to pure finance which added value to the customerand which were based on a knowledge and understanding of the assets, for example maintenanceupgrades, and facilities management in which an asset register was kept.

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8.483. There was a fundamental difference between the asset finance approach and the bankinglending approach. The security for the majority of asset finance business was always the asset. It did notrely on any debentures or other form of security. There was an understanding of the nature of the assetand the industry in which the asset had been used, which had led to some businesses gaining muchexpertise, which could be important in larger or marginal decisions. A more important consideration wasthe ability of the customer to repay. In high capital value assets, manufacturers had a keen interest intheir customer bases, and industries were becoming quite heavily integrated with provision of finance. Inparticular the plant and machinery manufacturing industries were tending to align themselves with manu-facturer-owned or -dominated in-house facilities.

8.484. The principal competition to FLA bank members, therefore, was point-of-sale finance, manu-facturing captives and other providers of asset finance such as GE Capital Bank and its various com-ponents that were all strongly represented in the FLA. It saw its bank members competing against all ofthe asset finance market. General experience was that most customers would have a primary list of threecompanies and it would be the most price competitive of the three that they would tend to select,although broader relationship, service and reputation played a significant part in medium and larger busi-ness markets.

8.485. The FLA said that because competition was very intense, margins in the SME asset financeprovisions were very tight, approximately 2 per cent over the relevant cost of funds, from which the costof bad debt could be 0.5 per cent, administration 1 per cent, leaving a 0.5 per cent net margin, too tightfor the risks being taken. Business was often introduced through dealers and manufacturers were then ina strong position to put a lot of pressure on the asset finance companies.

8.486. When providing a full asset management service, companies were taking on the residualvalue on assets and were adding a whole series of other services with added expertise. Returns on thatend of the business were better than the increasingly commoditized area of hire purchase. Similarly withfinance leasing, if companies were just to provide finance, the margins and the returns would be verylow.

8.487. It was clear that asset finance, either in the form of leasing or hire purchase, played a key rolein financing UK SMEs. Small firms depended more heavily on leasing than large firms and unquotedcompanies were more reliant on leasing than quoted companies. The FLA believed that smaller and/orunquoted companies had difficulties in raising external finance and instead relied more on leasing tofinance their investment projects. The BRT had mentioned the persistent worry that the provision ofcredit was not well suited to SME needs, a worry usually focused on the inappropriate use of overdraftsto finance investment: asset finance addressed that concern.

8.488. The FLA agreed that further to a report by HM Treasury on the financing of the early stagetechnology businesses, venture asset finance could also be part of the answer to financing this sectorefficiently, if the UK constructed the right framework to encourage it. Equity also had its place in fund-ing SMEs, but asset finance made a significant contribution to ensuring that longer-term assets werefinanced in an appropriate way, and that trend would continue to grow.

8.489. It also believed that asset finance would have an impact on competition. The market waschanging as new and existing players competed for SME business and asset financing’s focus on aphysical asset was a market advantage rather than a constraint: it was likely that a significant shift inasset finance rates would have a material impact on competing products’ prices, including bank debt.

8.490. With regard to tax, the FLA believed that it did introduce bias into the financing of invest-ment in critical ways. The provision of capital allowances for SMEs was a topical example. Recenttemporary regimes for these allowances had discriminated against leasing. There had been widespreadcall for this discrimination to be ended in the permanent regime that the Chancellor of the Exchequer hadproposed in the 2000 budget and which had been implemented in the Finance Act 2000. The FLAstressed that it was not asking for special or specific tax shelters for asset finance, simply equal treatmentwith other sources of finance for SME investment, which would also make the market for SME financemore transparent.

8.491. The FLA included a variety of institutions, but since asset finance was provided to a signifi-cant extent by banks and their asset finance subsidiaries, the Banking Review was right in claiming thatthere was considerable joint supply of products to customers.

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8.492. However, the quantity of joint supply was much less than the market share data indicated,since much asset finance was provided to firms directly by the finance subsidiaries, with only a smallminority referred by bank branches. This, however, would not be the case for some of the bank-ownedasset finance businesses but bank-owned asset finance arms did significant business with customers ofother banks. There were also very large other players in the market, both in the ‘captive’ market and theindependent finance houses: unlike the banks, such competitors were unregulated and not constrained byweighted risk asset requirements. Therefore, because of the competitive element, margins wereextremely tight.

8.493. Joint supply was convenient for the customer, and promoted a better understanding of cus-tomer needs by bank suppliers, providing it took place in a competitive environment: it was not providedon a compulsory basis, but was a matter for commercial judgement. Unbundled products were availablefrom banks and other suppliers. For example, factoring was an important source of finance for manySMEs. Whether provided alone or not, it would often be part of a bank’s portfolio of SME products. TheFLA supported this ‘cocktail’ approach to the provision of SME finance, since it allowed SMEs to tailortheir financing to their commercial circumstances, especially in financing their investments. However,equality within the tax treatment of asset finance was an essential missing ingredient. An increasing pro-portion of SMEs were substituting asset finance for secured term loans, and the Banking Review wasright that there was further scope for expanding this market. The customers were, however, also aware ofthe alternative sources of such finance.

8.494. The FLA concluded that there was a great deal of competition between asset finance andother sources of finance; and significant competition also within asset finance, in the various markets thatthe inquiry was considering. Barriers to competition concerned competition with other sources offinance, including SMEs’ internal resources. These came mainly from the tax system, which biasedfirms’ decisions on financing against leasing, for example recent temporary capital allowance regimesand the new permanent one.

The Small Business Agency

8.495. The Small Business Agency believed that the results of a study by the Ulster Society ofChartered Accountants into financial structures and the products available to SMEs would show that thebanking sector in Northern Ireland was competitive in terms of interest rates. Whereas, at times, individ-ual businesses had difficulty in acquiring appropriate levels of banking funding, there was no evidence tosuggest a non-competitive environment existing in the Northern Ireland context.

A former bank employee

8.496. A former bank employee commented on the Statement of Issues (see Appendix 2.1).

8.497. He said that the high street banks had similar price levels and this was inevitable in anoligopoly. However, as one bank pointed out at the CC’s open meeting, the market would not acceptincreases in charges in nominal terms, therefore competition was not dead. There were also specialistunbranched banks that ran high-interest cheque accounts for SMEs.

8.498. There was different competition for different products. For example, interest on currentaccounts was not available to SMEs at present among the high street banks, but notional allowances oncredit balances (which were set off against transmission charges) were becoming more common.Unbranched lenders offered loans, except at the lowest levels. An overdraft required a current account,so competition was usually more restricted.

The possible complex monopolies

8.499. Differentiation in charges to personal and business accounts was reasonable. The majority ofSME accounts had more account activity than most personal accounts, which cost banks more to run. No

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high street bank was likely to achieve sustainable benefit by introducing credit interest on SME currentaccounts across the board. This lack of benefit from easily replicable innovation was a standard featureof oligopoly.

8.500. Negotiation was used to differentiate charges between customers. However, most SMEs knewthat charges were fixed individually, but very few knew the ‘going rate’ for their level of business.Borrowing SME customers effectively accepted what they were given as the availability of borrowingfacilities was much more important to them than the level of transaction charges.

8.501. Loans to SMEs from high street banks were usually made available on the basis that thelender had the operating current account, or, at the top end of the SME market, an operating currentaccount. There was no intrinsic reason why this should happen and banks should be encouraged toabandon this requirement.

8.502. Current clearing bank practices did make it unnecessarily difficult for SMEs to switch banks:ideally sort codes and account numbers should be portable between banks, and the proposed PayComshould force banks toward this. Outsourcing of clearing functions would not promote innovation.

8.503. On the suggestion in the Issues Letter of lack of transparency in charges, particularly loanterms, there seemed to be confusion between costs and pricing. Risk assessment was part of the potentialcost of the loan to the provider. The price was expressed as an interest formula plus fees and was easy tocompare with other quotes. There was no special argument for forcing banks into open book pricing forSME borrowing facilities. The request for a written explanation of the risk assessment, which wouldraise bank costs, had come from the Forum of Private Business, the same body whose members hadcomplained that bank charge tariffs were already too complex.

Issues

8.504. It was clear from the Cruickshank report that banks were already collectively operatingagainst the public interest in the payments area, for example in the arrangements for credit card inter-change rates. The banks had also been slow to innovate in accepting credit card payments in US dollarsand card payments over the Internet. Banks collectively lacked the commercial incentive to innovate tobring down the cost of clearing cheques drawn on an EC bank nearer to domestic levels. This wouldrequire inter-governmental pressure at EC level and was a good argument for establishing PayCom.

Market definition

8.505. The Cruickshank report also established good data on the fragmentation of various productmarkets. The only unique products the high street banks had were overdrafts and the acceptance of cash.They were also effectively the only source of small loans for SMEs. Every high street bank tried to makeit easy for SMEs to buy at its ‘one stop shop’—but factoring and leasing were often bought elsewhere, aswere merchant services.

8.506. The Cruickshank report had overemphasized local and regional markets. Competition at highstreet level might be more aggressive in certain areas, for example London, but this was mainly inresponse to greater customer ruthlessness about shopping around for the best price.

Effectiveness of competition

8.507. Price competition was no more effective than would normally be expected from an oligopoly.However, historically Girobank had moved the market downward with its pricing policy for receivingcash. Strategies also differed as, for example, toward the scale of activity at which banks aimed, inmerchant services. The pricing of loans might be similar, but different banks handled risk assessment andaftercare in different ways.

8.508. There could be operational advantages in having all current accounts at one bank for all butthe largest of SMEs. The high street banks offered incentives for SMEs to buy other services from themand this in itself indicated that there was no great compulsion to do so. However, it should not be neces-

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sary to have a working current account alongside a loan, although it was almost invariably a requirement.Security could inhibit taking banking services from elsewhere, for example if an SME had given a fixedand floating charge over all assets of its company, obtaining finance from elsewhere could be difficult.General overdraft terms, however, were generally not such as to make it hard to obtain finance else-where. There could definitely be a benefit in a long-term relationship with a bank, but there was nothingsinister about this.

8.509. During the public session of the open meeting, one bank had pointed to garages as a branchsystem to service SMEs. This was ingenious but untrue, as staffing and security arrangements would notbe up to the job. It was also suggested that local post offices and large retailers could handle cashdeposits. The CCBS had argued that sub post offices could not handle SME deposits, and apart fromsecurity considerations SME customers in high numbers would cause unacceptable queues at a typicalsub post office.

8.510. The Cruickshank report made much of whether new entrants smaller than clearing banks weredisadvantaged by lack of information on SMEs. However, the information would often be too general tobe of value in any particular case. There was also too much variation within sectors. What mattered waswhether an individual business was well run and profitable, and at this level, most public statistics weredated and untypical. New entrants would want to ‘cherry-pick’ with the benefit of credit scoring.

Profitability and prices

8.511. Excess of prices over costs was to be expected in an oligopoly; and it was not easy to see howregulation could change this.

Relationships between SMEs and clearing banks

8.512. Most overcharging was accidental, and often caused by staff inputting information late, incor-rectly or not at all, or by systems defaulting to penal excess rates when no limit information was input.However, banks were getting most things right most of the time and there was no conspiracy.

8.513. There was a power imbalance between SMEs and the clearing banks. Many businessesrelying on overdraft facilities felt that they were negotiating with the bank on their knees. NatWest’sremoval of the ‘on demand’ clause for SME overdrafts—a change that seemed reasonable and overdue—would shift this balance slightly, but the basic imbalance could not be changed. Some competitors saidthat customers did not complain about these clauses, which demonstrated how many customers acceptedsome banking practices without question.

8.514. SMEs that were in difficulties negotiated with their bank not on their knees but over a barrel.Banks, at their discretion, placed such business under special watch. Typically, monthly fees were leviedfor supposed extra support and monitoring, which brought the customer no extra benefit but was for thepurpose of the bank’s advances control offices. Accountants might also be asked to investigate and reportto the bank at the customer’s expense: these investigations often revealed nothing new, increased thecustomer’s bank debt as a result of the fees, and could lead to profitable liquidations. Banks should onlybe able to impose such costs when provision has been marked on an account—that is, when there was arisk of loss.

8.515. Several decades ago, banks did not sell insurance, and insurance was rarely stipulated as arequirement for a borrowing SME. The banks started to sell insurance, and then various insurancesgradually became a requirement of certain borrowing. From a public interest point of view, this shouldonly be permitted when absence of insurance would put the bank’s debt at risk. Then, key person insur-ance might be necessary for an unsecured borrowing, but if the borrowing was covered by tangiblesecurity, the choice of whether or not to take out an insurance policy should rest with the customer.

8.516. The banking ombudsman service covering banking services was slow, uninformed and incon-sistent. It seemed essentially to conduct a remote dialogue with the parties and then reached a decision.As noted above, a body such as PayCom was necessary to drive down the costs to SMEs of shortcomingsin payment systems. However, there were no significant problems as regards transparency in loanproceedings.

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8.517. On quality of service, banks set their own standards and were self-policing. Compensationschemes were marketing driven and could reduce costs at the margin if staff were encouraged to workbetter. Incentives for rapid resolution of disputes were minimal. However, effective regulation in theseareas would be weighty and the costs could outweigh the benefits.

Possible remedies

8.518. Possible regulatory remedies were misconceived, similarly many of the possible behaviouralremedies to remove barriers to entry. Assistance to switching was supported, particularly portability ofsort codes and account numbers, and although bundling was not a major problem, banks should bepersuaded to do some limited unbundling. Detailed regulation of banks’ relationships with SMEs wasalso likely to be heavy handed and overtaken by events, although the banks had a case to answer oninsurance.

Individual small businesses

8.519. We received comments from a number of individuals.

8.520. An SME believed that banks should not be allowed to hold guarantors’ collateral, destroycompany guarantors’ integrity or reduce honourable people’s quality of life, making them penniless.

8.521. One SME said that its bank was not honouring agreements, whether verbally or by writtencontract. The withdrawal of credit facilities, without proper notice or consultation, had caused addedproblems, such as the reduction of credit limits. Opportunities to buy ahead in bulk had also been denied.It believed it was wrong for banks to use their position to increase the costs to a company: for example,through advice given by accountants, charging excess borrowing and returned cheque fees in a situationtotally created by the bank’s own actions, or charging arrangement fees which were excessive whenviewed against the time elapsed. It was detrimental to the development of a business to have decisionsmade by a bank far away, without customers having access to the decision-makers.

8.522. Another SME complained about the charges banks made for merchant and other services.Although charges had to be made, small businesses should be charged on the same basis as largercompetitors. The merchant acquirer had argued that the higher charge was due to the incidence of theft ofcards, but a larger store with more card transactions was likely to encounter more fraud and charge-backsthan small shops; furthermore a sole trader would be likely to be more vigilant with regard to fraud thannumerous ‘employees’. Computer transfers cost the same, whether a business was small or large, yetsmaller businesses were charged more per transaction/cheque.

8.523. Another SME told us that despite its excellent track record with no overdraft for severalyears, limited borrowings and healthy profits, it was unable to obtain the full borrowing facility itrequired from its existing bank, and the facility it was offered required a combination of debenture andpersonal guarantee to virtually the full amount of the proposed loan. Companies with excellent trackrecords and genuine good banking relationships should be able to raise bank borrowings without deben-ture or personal guarantees. Such restrictions also affected new entrepreneurs. Due to banks restrictingtheir risk levels with SMEs, the SMEs were remaining extremely cautious and not taking the necessarybusiness risks associated with increased investments, expansion, exports etc. If the UK were to expandits base of entrepreneurial companies, then a new form of ‘up to £1 million’ risk capital was required. Allbanks operating in the UK should deposit just once a sum equal to, say, 1 per cent of their financialyear’s turnover into a special UK SME Business Expansion Fund. This fund would then loan money outto SMEs, unsecured at between 1 and 5 per cent above Bank Base Rate according to the amountborrowed.

8.524. Another SME told us that it had a history of agreements for loans and overdrafts and at alltimes its bank had been highly supportive, both in good times and in bad. In part, this was attributed tothe principles it followed of putting forward a creditable, not exaggerated, business plan; letting the bank

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have well-presented, accurate and prompt monthly accounts; telling the bank when things went wrong;and to repay slightly earlier than the agreed schedule.

8.525. Another SME told us that he had been appalled at his bank’s harsh attitude and lack of con-sideration for a long-serving customer when applying for a bridging loan (his account being used forboth personal and business transactions). After carrying out some research he believed there existedsome form of cartel among the big banks. He felt that costs in particular arrangement fees as a percentageof the loan and interest rates on loans were unreasonable. He believed banks used their monopolisticpower to exploit their customers.

8.526. An employee of a provider of structural finance (invoice discounting/factoring) told us thatthere were numerous examples of clearing banks which would prevent their customers using other com-panies’ services, for example by threatening to withdraw facilities (such as overdrafts), or much reducingthe cost of their own services.

8.527. An individual told us that the high cost of loans to SMEs partly resulted from the capitalrequirements of the BoE and BIS rules: tax relief on income generated from small businesses couldremedy this. He also proposed establishment of a conglomerate entity to provide facilities for SMEs tohedge against currency exposure.

8.528. An individual SME complained about exorbitant fees—of over 2 per cent of the value of aloan—being charged payable upon drawdown of a loan.

8.529. An individual SME said that it had recently opened an account with one of the clearing bankswith an overdraft facility, having been assured that no cheques would be bounced without speaking to theSME and if, as was the case, security and solicitor undertakings were in place. Nonetheless, thisoccurred, with the bank charging £30 on each refusal. The SME believed he had been misled.

8.530. A writer and publisher complained about lack of training and competence of staff by thebanks, as a result of which they did not give enough attention to his enquiries for finance.

8.531. A consultant expressed concern about the creation of new money by the banks in the courseof their lending to current account customers, representing a large hidden subsidy to the banks, andmaking it more difficult for new entrants.

8.532. A small business told us that bank charges were too high: there should be no such charges,given the income the banks earned on funds in current accounts.

8.533. Another SME said that the present atmosphere of opposing interests, undue influence andprofiteering involved in the relationship between banks and business customers needed to disappear. Oneor two business-only banks catering for SMEs should be established, with multi-skilled teams availableto give proactive support for particular types of business and encouragement for their experience orconsolidation. The present monopolistic banks could be made to capitalize such a business-only bank.The business also complained about being given very short notice that the account would be overdrawn;although cash was almost immediately paid into the account to prevent the overdraft arising, direct debitswere not paid, and an extortionate charge for non-payment was levied: the banks argued that the fundshad to be in the accounts the day before they were due to be paid.

8.534. An SME complained about the banks’ blanket policy of non-issue of card merchant facilitiesto relatively new or small agents or tour operators in the travel trade.

8.535. A small retailer complained about charges on electronic card sales, equivalent to over 10 percent of sales: businesses with higher turnover paid considerably less, which was unfair and anti-competitive.

8.536. An employee of a provider of structured finance said that a potential customer, unhappy withthe service provided by the factoring subsidiary of a clearing bank, was told that if it left that subsidiary,its overdraft facility could be withdrawn. It was unlikely that another factoring company could replacethe overdraft as well. The long-winded and cumbersome process of changing banks meant that mostclients would put up with the poor service and high cost. Other clearing banks responded to the threat of

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a client leaving by much reducing the cost of the facility under threat. These were regular difficulties fornon-bank-owned finance companies.

8.537. An SME complained about delays in cancellation of guarantees and other errors by a clearingbank.

8.538. An SME complained about errors made by a clearing bank in calculating charges; breaches ofthe code of conduct; refusal to help the business when in difficulty by rescheduling the debt or freezinginterest; imposition of penal charges and arrangement fees; introduction of managed rates of interestwithout the required notice; failure to answer questions; taking money by stealth from accounts; forcingagreements to be signed by threat of bankruptcy proceedings; and failure to repay monies due.

8.539. An SME complained about a clearing bank providing misleading information in itsConditions about the scope of solicitors’ services.

8.540. A former bank employee said that any complex monopoly that existed was partly a result ofthe cultural development of the British banks, producing banks dependent on security and the trackrecord of the individual to reduce risk. A consequence was the lack of any quasi-partnership between thebank and their business customers, and lack of commitment to full training of both small businesses andbusiness banking managers. The lack of fully trained business banking managers, who could trade theirexpertise between banks, was a major problem in increasing competition.

8.541. Among the CC’s hypothetical remedies, it was naive to suggest that a loan account could begranted by one bank while another maintained the operating account; a stand-alone loan account mightattract higher interest charges because of higher risks resulting from lack of up-to-date information.Some of the hypothetical remedies proposed by the CC could reduce the commercial freedom of thebanks, resulting in fewer competitors.

8.542. A consultancy firm said that it would welcome a new watchdog to oversee charges, bettercomplaints procedures, and emergence of new banks.

8.543. A small firm believed the problem of serial overcharging was more common than generallyrecognized.