The UK Retail Banking Sector - Is Competition Regulation Working?

The UK retail banking sector- Is competition regulation working?

This article was first published on Lexis®PSL Competition on 26 February 2014. Click here for a free 24h trial ofLexis®PSL

Produced in partnership with Suzanne Rab

'Britain has one of the most concentrated banking systems in the world' asserted Ed Miliband,

leader of the opposition in a recent speech calling for the introduction of greater competition into

the UK banking sector. This clarion call for action provides a timely opportunity to review the

current debate about the state of competition in UK retail banking.

References: BBC News, 'Ed Miliband urges bank branch sell-off to tackle 'broken' market',

17/01/2014

Banks have received much negative attention since the financial crisis. Criticism maintains that a

lack of competition has led to poor service and a reluctance to lend. At least on first impression, the

case for action might seem to be relatively clear with a small number of banks owning the majority

of branches and in control of most of the UK's financial machinery. However, a closer inspection

reveals a more complex picture. The issues have been discussed over and over in different

contexts, yet views are divided on what needs to be done. High levels of concentration, limited

switching, barriers to entry--these issues recur as topics for regulatory probes. The question that

now arises is 'should governments, competition bodies, regulators or someone else do more to

address this situation?'

There is, perhaps, no other sector that has undergone more UK market studies and investigations

than retail banking. The focus of these inquiries has been not so much on whether individual

companies are infringing competition law but on whether there are features--including structural

features--which mean that banking markets do not work as well as they should. The proposal by

Ed Miliband that what is needed to remedy the effects of years of (relatively) unfettered

consolidation is the creation of two new 'challenger' banks has forced the issue of market structure

to the front of the policy agenda.

The experience of competition law interventions in the UK retail banking sector in the last decade

has been, at best, disappointing. There are some fundamental issues to be resolved regarding the

role of the competition authority, government and sector regulators. Difficult terrain will need to be

navigated, a route through is suggested, one which considers the opportunities to be embraced

and potential snares to be avoided, if the next period of UK retail banking competition is going to

be any different from the last.

UK retail banking a potted history-how did we get to here?

It is useful to begin with some historical background to chart the changes in the UK retail banking

markets and regulatory landscape. In 1918, the four largest clearing houses held 67% of all

deposits. Concentration has been growing over time. It is convenient to begin with the post-war

years which is when the structure of the industry began to change and start taking on the shape we

see today.

UK retail banking market structure and regulation chronology

Key regulatory milestones and trends:

Period Key market structure

events

Key regulatory events Themes

UK retail banking consolidating

1960s - 1970s o Merger of National

Provincial Bank and the

Westminster Bank

(becomes National

Westminster) (1968)

o Proposed merger of

Barclays, Lloyds and

Martins Bank. MMC

recommended against

the merger of Barclays

and Lloyds. Barclays

acquired Martins (1968)

o Inquiry into bank

charges by National

Board for Prices and

Incomes (1966)

o Focus on retail

(deposit-taking and

lending)

o Growth of money

markets

o Increasing popularity

of building societies

Regulatory change

1980s o Acquisition of Royal

Bank of Scotland by

Hong Kong and

Shanghai Bank.

Prohibited (1982)

Financial Services Act

1986

Building Societies Act

1986

o Shift from self-

regulation to public

regulation (though

banks were still

regulated by the Bank

of England)

o More commercial

flexibility for building

societies

Defining the frontiers of consolidation?

1990s o Acquisition of Midland

Bank by Hong Kong

and Shanghai Bank

(becomes HSBC)

(1982)

o Acquisition of Trustee

Savings Bank by Lloyds

(becomes Lloyds/TSB)

(1995)

o Acquisition of

Cheltenham and

Gloucester by Lloyds

(1997)

o Acquisition of

National Westminster

by Royal Bank of

Scotland (contested by

Bank of Scotland)

(1999)

o Bid for Abbey

National by Lloyds.

(prohibited-2001)

o Acquisition of Halifax

by Bank of Scotland

(becomesHBOS)

(2001)

o Increased

consolidation

o Most mergers were

approved or not

considered to raise

competition issues

o Creation of a new

'challenger' bank

(HBOS)

o Lloyds/Abbey merger

prohibition-suggested

further mergers by the

Big Four would be

difficult

Towards the financial crisis and beyond

2000s o Acquisition of the

Woolwich Building

Society by Barclays

(2000)

o Acquisition of Abbey

National by Santander

(2004)

o Cruickshank Report

(2000)

o New merger control

public interest ground

of ensuring 'the stability

of the UK financial

market'

o Further consolidation

up to and during the

financial crisis

o Bank rescue

packages

o Sale of Bradford and

Bingley assets to

Santander (2008)

o Acquisition of Alliance

and Leicester by

Santander (2008)

o Merger of Lloyds and

HBOS (2008)

o Sale of Northern

Rock to Virgin (2012)

o UK scheme to

support the banking

sector--recapitalisation;

guarantee scheme and

short-term liquidity

measures (2008)

Reshaping the banking market

2010s o Entry of Metro Bank

(2010)

o Report of the

Independent

Commission on

Banking ('IBC') (2011)

o Financial Services

Act 2012

o Financial Conduct

Authority gets

concurrent powers to

apply competition law

(2013)

o Merger of OFT and

Competition

Commission and

formation of

Competition and

Markets Authority (to

take place on 1 April

2014)

o Sustained focus of

regulators on retail

banking

o Re-emergence of

divestment as a

regulatory solution

o Streamlining of

mainstream competition

enforcement

o Competition now

within the remit of the

financial services

regulator

o Retail banking

remains a high-profile

political issue

Competition intervention in banking

A number of key aspects of the financial services sector and particularly banking make it a natural

priority and interest area for competition and regulatory authorities.

First, these are consumer facing businesses. There are obvious political 'wins' from interventions

because a high level of consumer benefit might be expected. Also, the practices may affect

vulnerable consumers.

Second, business practices that raise eye brows for regulators tend to be prevalent across the

industry rather than being confined to particular companies. Whether the focus is on cross-selling

of financial products, unauthorised overdraft charges or special rates for particular types of

customers, these business practices or models do not tend to be unique to a particular bank. Thus,

there can be significant benefits and efficiencies in intervening across the sector. Individual

enforcement action in specific cases is also unlikely to be effective when the practices are more

endemic.

Third, the sector is regulated by a prudential regulator but is also subject to general competition

law. This dynamic is relevant considering the proper boundaries of supervision and intervention

and the inter-institutional action between the competition authority and sector regulator. In the past,

in the UK both the competition authorities (specifically, the OFT) and the sector regulator (formerly,

the FSA) have used the language of 'treating customers fairly'. However, at least from the historic

perspective it is evident that they did not always have the same thing in mind. This suggests a

distinction between process and outcomes may be more relevant than the traditional 'ex ante' and

'ex post' distinctions which are often used to mark out the boundaries between competition law and

sector regulation. On the one hand, the FSA has traditionally been concerned with the process

regulated companies adopt when dealing with customers (ie, transparency and the provision of all

relevant information on which to make an informed decision). On the other hand, the UK market

investigations regime (which has its basis in competition law) is much more outcomes-driven (for

example, when assessing possible remedies in terms of customer benefits).

Fourth, the competition issues are deeply suffused with policy questions. This is apparent when

looking at the historic evolution of regulation of the sector which has morphed from a form of 'club

governance' to one where there are high hopes for competition. At the same time, the way in which

competition policy interfaces with non-competition issues such as financial stability has been

developed piecemeal (see further below on the financial crisis). This presents a challenge when

considering the independence and oversight of regulators in the institutional landscape, how the

financial services regulator exercises its concurrent powers and how to safeguard against the

susceptibility of regulators to politicisation and capture.

Fifth, despite the national dimensions of the banking sector this is an area where UK policy also

interacts with EU policy. The retail banking sector has been subject to an EU sector inquiry. This

raises an interesting question of how the bolt-on of EU law sits with national policy in a sector

which has seen quite dramatic domestic changes in the last 100 years.

References: European Commission press release--IP/07/114-sector inquiry into banking,

31/01/2007

Finally, the sector has seen increasing consolidation and there are acknowledged entry barriers

(see below, Table 'entry barriers into retail banking'). In over 100 years there has only been one

completely new high street entrant--Metro Bank. This has raised questions about how difficult it is

to enter UK banking de novo and whether a more activist competition policy is needed to effect

structural reforms.

Retail banking and entry barriers

Type of potential entry barrier Example

Approval process Information requirements

Timescale for approval

Liquidity requirements Capital ratios depend on the riskiness of the activities

Branch network Important for personal current accounts and SME

banking markets

Brand Trustworthy reputation needed to grow scale

Access to infrastructure Access to money transmission network

Exit barriers If banks are rescued as 'too big to fail' this weakens the

incentives on new entrants to compete

However, there remains a debate about whether the barriers that have been traditionally seen as

barriers remain barriers at all. Take the issue of branches. The traditional thinking is that new

entrants need to build up their network and branch presence. This is highlighted in the IBC's Final

Report, amongst others. With consumers using online banking, the idea that branches represent a

barrier to entry has been questioned. The growth of HSBC's First Direct with a market share close

to 14% of UK current accounts yet about 1,000 fewer branches than the Royal Bank of Scotland

which has a smaller market share reflects this phenomenon. In this context, the probable call for

banks to sell off more branches has come under criticism as not properly targeting the main

obstacles to competition.

References: The Telegraph, 'Is competition in retail banking a problem?', 15/01/2014

Banking under investigation

A perennial theme of the last decade or so has been the succession of reports, market studies and

investigations in the UK retail banking sector. Of most immediate interest are the Competition

Commission's inquiry into SME banking services, the Competition Commission's inquiry into

current accounts in Northern Ireland and a succession of inquiries and reports from the OFT into

personal current accounts ('PCA').

References: Competition Commission. Personal Current Account Banking Services in Northern

Ireland market investigation (2007)

OFT--Personal current accounts in the UK (2008)

OFT--Personal current accounts in the UK: A follow up report (2009)

OFT--Personal current accounts in the UK: Progress report (2010)

OFT--Personal current accounts in the UK: Progress report (2011)

OFT--Review of the personal current account market (2013)

Among the issues that have been repeatedly identified have been:

o high levels of concentration o low levels of switching o lack of transparency in charges o barriers to entry and expansion.

The PCA-market has come under particular scrutiny. In the OFT's most recent (2013) report on

PCAs--Review of the personal current account market-- it was found that there has been increased

concentration since 2008. It has noted that consumer awareness still remains low but it hopes that

the new switching arrangements introduced in 2013 will bring about improvements. While the OFT

noted that there was room for improvement it decided against undertaking a market investigation

due to impending changes in the market (notably, the RBS and Lloyds divestments and the

establishment of the new Financial Conduct Authority ('FCA') with concurrent competition law

powers).

Standing back from the detail, there are some connecting themes in all of these investigations.

First, the remedies tended to focus on transparency and providing more information to customers.

Implicit in this approach is an assumption that providing more information would facilitate the

switching process. However, recent thinking on behavioural economics suggests that consumers

are not rational economic maximisers. There is not a straight correlation between providing more

information and improvements in switching. This raises an issue about the limitations of such

remedies and the proper boundaries between competition law and consumer protection.

References: OFT--Consumer behavioural biases in competition (2011)

Second, special caution is required if the remedies involve interfering with the pricing or design of

products. In particular, it may be erroneous to focus on the price element of competition where

complex products are involved and which may be more difficult for consumers to compare. Also, a

focus on price to the exclusion of other elements ignores that service can be an important

competitive differentiator in retail banking. Finally, the effectiveness of remedies cannot be

separated from issues related to the level of concentration and structure of the market. If the

market is concentrated, this concomitantly reduces the scope for new business models to emerge

and that will be attractive to consumers minded to switch (if they are so motivated at all).

Financial crisis and its aftermath

Consolidation increased during the financial crisis. It is worth a brief narrative of the changes in that

period to set in context the current debate. The period of most interest was from September 2008

when a series of events precipitated unprecedented solutions. Northern Rock had been taken into

public ownership after its collapse in 2007. Bradford and Bingley followed before the sale of some

of its assets to Santander.

It was the position of HBOS which brought into sharp focus the volatile position of the UK retail

banking sector. The markets were increasingly reluctant to lend to banks and banks were reluctant

to lend to each other. HBOS was more exposed than most to the property market and it became

clear that it would require significant government support to survive. A merger between HBOS and

Lloyds (then the fourth and fifth largest banks in the UK) would usually have raised competition

problems. A reference to the Competition Commission would have entailed a six to eight months

review at a time when solutions were needed practically over a weekend if not overnight. The usual

merger control process was dis-applied in this case and the Enterprise Act 2002 was modified to

provide for a new defined category of public interest--'the stability of the UK financial market'--

which prevailed over any competition issues. The OFT's October 2008 report identified a number

of competition concerns in the markets for personal current accounts, SME-banking and mortgage

lending. Ultimately, on 31 October 2008 the government decided against a reference to the

Competition Commission on the basis that 'the stability of the UK financial market' took precedence

over any potential competition issues.

References: OFT--Anticipated acquisition by Lloyds TSB plc of HBOS plc (2008)

The Lloyds/HBOS merger was followed by a more general scheme of state support for the banking

sector which the Commission approved under the EU State Aid Rules. This was coupled with a

scheme to divest some of Lloyds' retail activities. Another case study concerns RBS which made

commitments to divest its branch retail and SME operations (in England) and the NatWest (in

Scotland).

Both of these packages of commitments involved an assurance that the buyer would be

independent of the divesting group and have a market share of no more than 14% in the affected

markets. However, the experience of both RBS and Lloyds in trying to sell off their branches

illustrates the difficulties in achieving that, not least due to the technology and integration issues

and expense. Lloyds, for example, reportedly spent at least £1b creating TSB yet the move is

expected to make a minor dent in its mortgage market share. This situation has raised the criticism

that such sums might have been better spent on lending rather than IT separation.

The financial crisis and its aftermath has invigorated the debate about barriers to entry and the

phenomenon whereby banks are deemed 'too big to fail'. Banks expect to be saved if they are in

trouble. This expectation is conducive to what economists describe as 'moral hazard' and overly

risky/aggressive behaviour. As noted above when considering barriers to entry, this factor may

also dampen competitive incentives. The reasoning is that wholesale lenders will lend to the bigger

banks because they know that the government will not allow them to fail. The result can be that

larger banks fund their activities more cheaply than the smaller banks which do not benefit from

this implicit protection. The IBC put a low estimate of the implicit subsidy provided by the taxpayer

in the order of £3bn to £4bn a year. Other estimates such as from the New Economics Foundation

have placed this as closer to ten times that amount.

Rethinking retail banking

Up to now, most of the competition interventions in UK retail banking have focused on behavioural

remedies. The frequency with which the sector has been the subject of a market investigation and

on all too-familiar themes raises a question about whether these interventions have been working

and whether they can ever be expected to be effective.

When concerns around market concentration have been raised in a merger control context, with

rare exceptions (eg, Lloyds/Abbey) the trend has generally been to allow consolidation and deal

with the fallout later (eg. RBS/NatWest and Lloyds/ HBOS).

This raises a question as to whether a change in approach is needed. There are signs that the

perennial targets for competition interest will continue to feature on the future regulatory agenda

(the CMA will be looking at personal current accounts starting in 2014). However, what is different

about the more recent debates is a greater emphasis on market structure.

The Final Report of the IBC while considering both competition and regulatory issues made a

number of important recommendations on ostensibly competition issues. These included the

recommendation that a new stronger challenger bank was needed. It thought that the best way to

achieve this was through the Lloyds divestiture process. While the government was largely

supportive it did see that the divestiture was a commercial issue for Lloyds.

Market structure has been given a more recent airing by Ed Miliband in a January 2014 speech

which provides a reference point for considering future reforms. His pledge appears more

definitive--to ask the CMA to report into how to create not one but two challenger banks. He also

plans to introduce a new market share threshold to seek to ensure that no bank can dominate the

market. A market share cap is a blunt instrument. There is speculation that Ed Miliband is

contemplating a 20% or 25% cap on the UK retail banking market share that could be held by an

individual lender. However, in the current market it appears that only Lloyds would be caught by

this. Further, a market share cap will come under attack as arbitrary and prone to manipulation. It

could lead to distortion where a bank that is reaching that level of market share decides to soften

its approach or fails to go the extra mile to retain customers who would, in any event, need to be

shed if its share nudges above the line. In a tight market others might follow suit.

The suggestion that the CMA will be tasked to examine 'how’ to create a new bank rather pre-

empts the question of 'whether' it should. The usual approach would be to frame an inquiry for the

CMA's independent review and recommendation rather than give it a narrow issue to determine

having already taken a (policy) decision as to the intended outcome. Currently, there is a

separation between the role of the CMA and politics but the solution that is being advocated blurs

the lines between what is a political issue and what is for independent determination. This brings to

the fore the question of whether the regulation and desired future state of UK banking is to be

decided by politicians, a competition authority or something between the two.

The future

Despite the reservations that have been raised against Ed Miliband's proposals this does not mean

that the attention put on the retail banking market is entirely misplaced. What is at issue is whether

anyone has yet put forward a feasible approach that will make a difference and that has a good

measure of economics, legal and industry support. A competition market investigation reference is

held in abeyance until 2015, although the prospect of an inquiry in the future and whose outcome

(let alone remedies) may not crystallise until 2016 does not answer the complaints of, for example,

SMEs who point to imperfections and limitations on access to lending that need attention now.

Turning to the 'future state' it is useful to conclude with a few observations to map out the territory

ahead.

First, there is a need for a clearer articulation of the role of government and the competition

authority. If Ed Miliband's statements are taken at face value they risk confusing the roles of

politicians and an independent competition authority.

Second, once it is accepted that challenger banks can add vigour to the current landscape there

remains a question as to how new entry is to be achieved and sustained. While regulatory barriers

to entry are not something that competition authorities are responsible for, sight of them should not

be lost. Bigger questions concern where other challenger forces will come from. This brings us

back to the debate as to what regulatory changes are needed to facilitate challenger entry.

Changes to the capital rules are not straightforward but where smaller entrants need to hold

significantly more capital than the larger banks this can operate as a barrier. The CEO of Secure

Trust Bank, one of the challenger banks, argues that enhancing competition is much more about

lowering entry barriers than selling off branches.

References: The Telegraph, 'Is competition in retail banking a problem?', 15/01/2014

It will be recalled that as early as 2000 Sir Donald Cruickshank made the argument for a utility-like

payment system. Whatever the current relevance of that model, it forces the question as to

whether an independently owned payments system would attract new entrants to risk capital.

References: Sir Donald Cruickshank. Competition in UK banking (2000)

Third, there is the issue about sustainability of new business models and whether banks will

succumb to pressures to relinquish their challenger zeal. As the CFO of Commerce Bank, Douglas

Pauls, said: 'The hardest thing about becoming a big bank is not becoming a big bank'.

Finally, there is the issue of the role of the FCA and how it applies its concurrent competition law

powers. Up until now the development of competitive retail banking markets may have been held

back by the absence of a specialist sector regulator whose remit was to promote competition. It is

still early days and care will need to be taken that the pursuit of early wins does not result in 'fishing

expeditions'.

The dividing line between competition law and sector and prudential regulation is blurring. This

suggests that we should probably be thinking more about achieving the right blend between them

rather than a balance or trade-off.

The UK Retail Banking Sector - Is Competition Regulation Working?

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