uk commission on banking

8/7/2019 Uk Commission on Banking

1/214

Interim ReportConsultation on Reform Options

April 2011

ICBIndependentCommissionon Banking


2/214


3/214

Interim ReportConsultation on Reform Options

April 2011

ICBIndependentCommissionon Banking


4/214

Ocial versions o this document are printed on

100% recycled paper. When you have fnishedwith it please recycle it again.

I using an electronic version o the document, pleaseconsider the environment and only print the pages whichyou need and recycle them when you have fnished.

Crown copyright 2011

You may re-use this inormation (excluding logos) ree ocharge in any ormat or medium, under the terms o theOpen Government Licence. To view this licence, visitwww.nationalarchives.gov.uk/doc/open-government-licence/ or e-mail: [email protected].

Where we have identifed any third party copyrightinormation you will need to obtain permission rom thecopyright holders concerned.

Any enquiries regarding this publication should be sent to:Independent Commission on BankingVictoria HouseSouthampton RowLondon

WC1B 4AD

This document is also available rom our website athttp://bankingcommission.independent.gov.uk/


5/214

Independent Commission on Banking | 1

Interim Report

Contents

Contents ...................................................................................................................... 1

List of acronyms ......................................................................................................... 3

Executive summary ................................................................................................... 5

Chapter 1: Introduction .......................................................................................... 11

Background..........................................................................................................................11

Summary ..............................................................................................................................11

Structure o the Interim Report......................................................................................12

Chapter 2: The need for reform in the UK banking sector ...............................15

What is the fnancial system or? .................................................................................15

Financial stability ...............................................................................................................17

Competition ........................................................................................................................26

Analytical ramework .......................................................................................................45Chapter 3: Current reform initiatives ................................................................... 51

Financial stability ...............................................................................................................51

Competition .......................................................................................................................59

Chapter 4: Reform options nancial stability .................................................63

Reorm options to increase loss-absorbing capacity ...........................................64

Structural reorm options to promote fnancial stability ....................................76

Impact on competitiveness ........................................................................................101

Conclusions .......................................................................................................................116

Chapter 5: Reform options competition ........................................................119

Structural reorm options to promote competition ...........................................119

Improving the switching process ..............................................................................123

Barriers to entry ................................................................................................................124

Promotion o competition by the Financial Conduct Authority ....................126

Other options ....................................................................................................................127

Conclusions .......................................................................................................................130


6/214

2 | Independent Commission on Banking

Interim Report

Chapter 6: Consultation questions ....................................................................133Glossary ...................................................................................................................137

Annex 1: Summary ofIssues Paperresponses ..................................................145

Annex 2: Non-bank nancial institutions .........................................................147

Annex 3: Cost-benet analysis of nancial stability reforms ........................151

Annex 4: Competition and concentration ........................................................167

Annex 5: Other regulatory reform developments ..........................................175

Annex 6: Tools for increasing loss-absorbing capacity ..................................179

Annex 7: Illustration of structural reform .........................................................189

Annex 8: Competitiveness ...................................................................................195


7/214


8/214


Interim Report


9/214


Interim Report

Executive summary

This Interim Reportsets out the Commissions current and provisional views on possiblereorms to improve stability and competition in UK banking, and seeks responses to thoseviews.

The need for reform

The fnancial crisis that began in 2007 exposed undamental weaknesses in the globalfnancial system and has had enormous economic costs in terms o lost output, higherunemployment and weakened public fnances.

In the build-up to the crisis lenders and borrowers took on excessive and ill-understood risks,and banks operated with excessive leverage and inadequate liquidity. Regulation permittedthe ratio o their assets to their capital base to grow ar too high to twice normal levels andthey could not access market unding when they needed it. When the crisis hit, bank balance

sheets proved poor at absorbing losses, and the complexity o many ailing institutions madeit impossible eciently to resolve them i.e. sort out which parts o them should ail andwhich should continue and how. To avert panic and ensure continuous provision o the basicbanking services upon which the economy and society depends, governments and centralbanks injected vast amounts o capital and liquidity into the fnancial system.

The crisis was global, and the UK, with its large fnancial sector, was badly aected. Nationaloutput in 2010 was 4.5% below its level in 2007 and 10% lower than i growth had continuedon its pre-crisis trend. Unemployment has risen by more than 800,000 since 2007. The publicfnances have deteriorated sharply, and the 2010 defcit exceeded 10% o GDP. Despiterecent de-leveraging, the total balance sheet o UK banks is more than our times annual

GDP. More than 80% o RBS and more than 40% o Lloyds are in state ownership. Competitionin UK banking has been seriously weakened as rivals to the largest retail banks have let themarket or been absorbed into others.

Beyond the immediate task o repairing bank balance sheets while restoring the normalow o credit to the economy at large, the challenge is to make the UK banking system morestable, and markets or banking services more competitive. The options discussed in thisInterim Reportare directed to those ends.

Reform options for stability

How to make the system saer or the uture? An important part o the answer is bettermacroeconomic including macro-prudential policy so that there are ewer and smaller


10/214


Interim Report

shocks to the system. Work by others internationally and in the UK aims to address this. Butthese shocks cannot be eliminated, and the UK will always be subject to global events.

Making the banking system saer requires a combined approach that:

makes banks better able to absorb losses;

makes it easier and less costly to sort out banks that still get into trouble; and

curbs incentives or excessive risk taking.

These goals are inter-related. The more that banks owners and creditors (other than ordinarydepositors) stand to lose when things go badly, the stronger are their incentives to monitorrisks in the frst place, and the greater is their capacity to shoulder losses without damageto others when risks go bad. Banks ought to ace market disciplines without any prospect otaxpayer support, but systemically important banks have had and still enjoy some degree oimplicit government guarantee. This is the too big to ail problem. Unless contained, it givesthe banks concerned an unwarranted competitive advantage over other institutions, and willencourage too much risk taking once market conditions normalise. It also puts the UKs publicfnances at urther risk, especially given the size o the banks in relation to the UK economy.On top o the taxpayer risk rom bank bail-outs, banking crises damage the public fnances

because o their eects on output and employment. Indeed the problem could arise in uturethat the banks are too big to save.

Banks must have greater loss-absorbing capacity and/or simpler and saer structures. Onepolicy approach would be structural radicalism or example to require retail banking andwholesale and investment banking to be in wholly separate frms. Another would be to belaisser-faire about structure and to seek to achieve stability by very high capital requirementsacross the board. The Commission, however, believes that the most eective approachis likely to be a complementary combination o more moderate measures towards loss-absorbency and structure.

Achieving greater loss-absorbency requires, frst, that banks hold more equity relative to theirassets and, second, that creditors, not taxpayers, take losses i necessary. On equity capital,an important step is the 7% baseline ratio o equity to risk-weighted assets in the Basel IIIagreement. The international community is considering augmenting this or systemicallyimportant banks. In the Commissions view, the available evidence and analysis suggests thatall such banks should hold equity o at least 10%, together with genuinely loss-absorbentdebt. That would strike a better balance between increasing the cost o lending and reducingthe requency and/or impact o fnancial crises.

The Commissions view is that the 10% equity baseline should become the international

standard or systemically important banks, and that it should apply to large UK retail bankingoperations in any event. Subject to that saeguard or UK retail banking, and recognising thatwholesale and investment banking markets are international, the Commission believes thatthe capital standards applying to the wholesale and investment banking businesses o UK


11/214


Interim Report

banks need not exceed international standards provided that those businesses have credibleresolution plans (including eective loss-absorbing debt) so that they can ail without risk tothe UK taxpayer.

On remedying the ailure o debt to absorb losses in the crisis, contingent capital and debtcapable o so-called bail-in might be able to contribute to improved loss-absorbency inthe uture. Loss-absorbency and stability might also be improved by ranking the claims oordinary depositors higher than those o other unsecured creditors.

Greater loss-absorbing capacity has the urther advantage that it may enable loss-sharingwithout requiring bankruptcy and thereby acilitate more orderly and ecient resolution oailing banks, limiting collateral damage. This may be o particular importance or wholesaleand investment banking operations, which tend to be highly complex and span severalcountries with diering insolvency regimes. Disorderly ailure o such banks is dangerous orthe wider fnancial system, and international agreement on means o allowing them to ailmore saely is essential.

Turning to the structural aspect o reorm, a ocus o the Commissions workis the question owhether there should be a orm o separation between UK retail banking and wholesale andinvestment banking.

Ring-encing a banks UK retail banking activities could have several advantages. It wouldmake it easier and less costly to sort out banks i they got into trouble, by allowing dierentparts o the bank to be treated in dierent ways. Vital retail operations could be keptrunning while commercial solutions reorganisation or wind-down were ound or otheroperations. It would help shield UK retail activities rom risks arising elsewhere within thebank or wider system, while preserving the possibility that they could be saved by the rest othe bank. And in combination with higher capital standards it could curtail taxpayer exposureand thereby sharpen commercial disciplines on risk taking.

Separation between retail banking and wholesale and investment banking could take variousorms, depending on where and how sharply the line is drawn. While mindul o regulatory

arbitrage possibilities at the boundary, the Commission believes that there are practicableways o distinguishing between retail banking and wholesale and investment banking. Bothsorts o banking are risky and both are important, but they present somewhat dierent policychallenges. For the most part, retail customers have no eective alternatives to their banksor vital fnancial services; hence the imperative to avert disruption to the system or theircontinuous provision. Customers o wholesale and investment banking services, on the otherhand, generally have greater choice and capacity to look ater themselves. But it is vital tofnd ways or the providers o these services to ail saely (strengthening market inrastructureand limiting banks exposures to each other will help). Markets or wholesale and investmentbanking services including their provision by shadow banks are also more international,

as must be policy towards them, whereas national policies can bear more directly on retailbanking.


12/214


Interim Report

As to the orm that separation might take, a balance must be struck between the benefts tosociety o making banks saer and the costs that this necessarily entails. Full separation i.e.into separate entities with restrictions on cross-ownership might provide the strongestfrewall to protect retail banking services rom contagion eects o external shocks. Butit would lose some benefts o universal banking. On the other hand, it is doubtul thatseparability o operational systems, though desirable or eective resolvability, would itselbe enough.

The Commission is thereore considering orms o retail ring-encing under which retailbanking operations would be carried out by a separate subsidiary within a wider group. Thiswould require universal banks to maintain minimum capital ratios and loss-absorbing debt(as indicated above) or their UK retail banking operations, as well as or their businesses asa whole. Subject to that, the banks could transer capital between their UK retail and otherbanking activities.

It is open to debate whether a retail ring-ence would give more or less banking stability thanull separation between retail banking and wholesale and investment banking. It would beless costly to banks because they would retain signifcant reedom to transer capital. Therequired UK retail capital level would constrain banks only when they wanted to go belowit to shit capital elsewhere, say to their wholesale and investment banking operations.But at times o overall stress it would not be desirable or the leverage o UK retail banking

operations to increase in this way.

Rather than pursuing more radical policies towards capital or structure, the approachoutlined above is a combination o more moderate measures. They nevertheless entail coststo banks, some o which all on the wider economy, but these appear to the Commission tobe outweighed by the benefts o materially reducing the probability and impact o fnancialcrises. The approach is also designed with a view to UK competitiveness, and to the UKsinternational obligations. In particular, so long as there are appropriate measures in place toprotect UK retail banking, the Commission is not proposing that UK banks wholesale andinvestment banking activities should have to meet higher capital standards than are agreedinternationally, provided that they can ail without risk to the taxpayer.

Reform options for competition

Measures to curtail the implicit government guarantee enjoyed by systemically importantbanks and to ensure that they ace the consequences o their risk taking activity are good orcompetition as well as or stability.

But more than that is needed to remedy the weakening o competition in UK retail bankingas a result o the crisis. Challengers to the large incumbents have mostly disappeared, andollowing its acquisition o HBOS, Lloyds currently has around 30% o current accounts in

the UK. This Interim Reportdiscusses three initiatives (beyond the continued application ogeneral competition and merger law) that could improve competition.


13/214


Interim Report

The frst concerns structural measures to improve competition. Although Lloyds is required todivest a package o assets and liabilities to satisy conditions or state aid approval set by theEuropean Commission, this divestiture will have a limited eect on competition unless it issubstantially enhanced.

Second, competition among incumbent banks, and between them and challengers, isblunted by the actual and perceived diculties or customers switching accounts, bypoor conditions or consumer choice more generally, and by barriers to entry. This InterimReportsuggests that it may be possible to introduce greatly improved means o switchingat reasonable cost, in which case the industry should be required to do this within a shorttimescale, and that barriers to entry may be able to be reduced.

Third, the Commission regards the Financial Conduct Authority proposed as part o theGovernments reorms o the regulatory architecture as potentially a vital spur to competitionin banking. The Authority will have regulatory tools not available to the general competitionand consumer authorities, and, in line with an earlier recommendation by the Commission,the Authority should have a clear primary duty to promote eective competition.

The international context

The Commissions remit is well-aligned with the international reorm agenda or fnancial

stability, which is being led by, among others, the Basel Committee on Banking Supervisionand the European Commission. The current work on systemically important fnancialinstitutions by the Financial Stability Board or the G20 is o particular relevance or theCommission. The UK authorities are centrally involved in these international initiatives, andone intention o this Interim Reportis to contribute to the international debate.

An important consideration or the Commission is how reorms to UK banking could aectthe competitiveness o UK fnancial services and the wider economy. The Commissionscurrent view is that the reorms o the kind contemplated in this Interim Reportwould supportthe competitiveness o the economy and would be likely to have a broadly neutral eect onfnancial services.

First, they would aect a relatively small proportion o the international fnancial servicesindustry based in the UK. Second, improved fnancial stability should be good, not bad,or the competitiveness both o the fnancial and non-fnancial sectors. The costs andconsequences (including or taxation) o fnancial crises make countries that suer them lessattractive places or international businesses to locate. More resilient banks are thereorecentral to maintaining Londons position as a leading global fnancial centre, not a threat toit. So while a urther domestic taxpayer guarantee might be to the advantage o some UKbanks in international competition, it would be a fscally risky subsidy without justifcation. Inany case, the location decisions o banks are aected by a wide range o actors that go well

beyond the issues that the Commission has been asked to consider.


14/214


Interim Report

Consultation

The purpose o this Interim Reportis to ocus the next stage o debate on reorm optionswhich, in the current and provisional view o the Commission, appear to have most merit. TheCommission welcomes views and analysis in response to it. The Commissions fnal report willbe published in September.


15/214


Interim Report

Chapter 1: Introduction

Background

1.1 On 16 June 2010, the Chancellor o the Exchequer announced the creation o theIndependent Commission on Banking (the Commission). Its members are Sir JohnVickers (Chair), Clare Spottiswoode, Martin Taylor, Bill Winters and Martin Wol.The Commission has been asked to consider structural and related non-structuralreorms to the UK banking sector to promote fnancial stability and competition.The Commission is independent rom Government, and will report to the CabinetCommittee on Banking Reorm by the end o September 2011.1

1.2 In September last year the Commission published an Issues Paper,2 which served asa call or evidence.3 The Issues Paperalso identifed a number o possible optionsor reorm. Since then, in addition to receiving submissions and gathering urtherevidence, the Commission has been consulting with market participants, academics

and regulators in the UK and internationally, and has held a series o public debatesaround the country. This Interim Reportrepresents the next stage in the Commissionspublic engagement.

1.3 The aim o this Interim Reportis to set out the provisional views o the Commissionon the need or reorm and on possible reorm options, and to seek views, evidenceand analysis in response. The Commission has not reached fnal conclusions on any othese matters.

Summary

1.4 Improved stability requires that banks, especially those o systemic importance, cangenerally absorb losses themselves, without reliance on the taxpayer, and that theirbusinesses can ail saely, without undue damage to the rest o fnancial system andthe wider economy. Various reorm initiatives are under way internationally towardsthese ends, including:

1 The Commissions ull terms o reerence are set out here: http://bankingcommission.independent.gov.uk/bankingcommission/terms-o-reerence/.2 http://bankingcommission.independent.gov.uk/bankingcommission/wp-content/uploads/2010/07/Issues-Paper-24-September-2010.pd3 A summary o the responses that the Commission received to the Issues Paperis set out in Annex1. Theresponses are available here: http://bankingcommission.independent.gov.uk/bankingcommission/responses/.
http://bankingcommission.independent.gov.uk/bankingcommission/terms-of-reference/http://bankingcommission.independent.gov.uk/bankingcommission/terms-of-reference/http://bankingcommission.independent.gov.uk/bankingcommission/terms-of-reference/http://bankingcommission.independent.gov.uk/bankingcommission/wp-content/uploads/2010/07/Issues-Paper-24-September-2010.pdfhttp://bankingcommission.independent.gov.uk/bankingcommission/wp-content/uploads/2010/07/Issues-Paper-24-September-2010.pdfhttp://bankingcommission.independent.gov.uk/bankingcommission/responses/http://bankingcommission.independent.gov.uk/bankingcommission/responses/http://bankingcommission.independent.gov.uk/bankingcommission/responses/http://bankingcommission.independent.gov.uk/bankingcommission/wp-content/uploads/2010/07/Issues-Paper-24-September-2010.pdfhttp://bankingcommission.independent.gov.uk/bankingcommission/wp-content/uploads/2010/07/Issues-Paper-24-September-2010.pdfhttp://bankingcommission.independent.gov.uk/bankingcommission/terms-of-reference/http://bankingcommission.independent.gov.uk/bankingcommission/terms-of-reference/


16/214


Interim Report

measures to enhance loss-absorbency and liquidity, both in general andadditionally or systemically important banks;

the development o recovery and resolution plans or banks that get into trouble;and

proposals to put in place sounder market inrastructure, including morecentralised clearing o derivatives.

The reorm options or UK banking canvassed in this Interim Reportare ully in accordwith these initiatives.

1.5 Further on stability, this Interim Reportaddresses the structural question o whetheror not orms o separation between types o banking activity should be part o theoverall package o measures to make the system saer. Specifcally, it considers thepros, cons, and easibility o orms o separation between retail and investmentbanking, as well as other sorts o structural reorm.

1.6 Beyond eliminating the distortion o the implicit state guarantee or too big to ailbanks, the Interim Reportexamines reorm options to improve competition in UKbanking, in particular:

structural measures to redress increased concentration and reduction inchallengers in UK banking;

measures to strengthen the power o consumer choice, or example by reducingswitching costs, and to reduce barriers to entry; and

the potential role o the new Financial Conduct Authority.

1.7 While stability and competition are the main objectives guiding the analysis in thisInterim Report, careul attention is paid to the issues o lending and the pace o

economic recovery, UK competitiveness, and the Governments fscal position.

Structure of the Interim Report

1.8 The rest o this Interim Reportis organised as ollows:

Chapter 2assesses the need or reorm in the UK banking sector ollowingthe fnancial crisis that began in 2007. The chapter identifes the stability andcompetition problems that must now be addressed, and sets out an analytical

ramework or the appraisal o possible solutions.

Chapter 3 places the Commissions work in the context o other UK andinternational banking reorm initiatives.


17/214


Interim Report

Chapter 4 examines reorm options principally aimed at improving fnancialstability, with particular emphasis on increased loss-absorbency and orms ostructural separation. It also assesses the likely impact o these reorm options oncompetitiveness.

Chapter 5 examines reorm options principally aimed at improving competition.

Chapter 6 brings together a series o questions or consultation that are spreadthroughout the preceding chapters, and provides inormation on how torespond.

The Glossary contains defnitions o fnancial terms used in this Interim Report.

Annex 1 contains a summary o responses to the Commissions Issues Paper.

Annex 2 describes the nature and activities o non-bank fnancial institutions.

Annex 3 analyses the costs and benefts o the Commissions current preerredreorm options to improve fnancial stability.

Annex 4 provides a summary o a review o the literature on the empirical link

between competition and concentration.

Annex 5 ollows on rom the fnancial stability section o Chapter 3 bysummarising regulatory reorm developments not already addressed in thatchapter.

Annex 6 contains details on the characteristics and eectiveness o dierenttypes o loss-absorbing capacity.

Annex 7 provides an illustration o how a retail ring-ence might be designed.

Annex 8 sets out additional evidence supporting the Commissions fndings onthe impact o the proposed reorm options on competitiveness.


18/214


Interim Report


19/214


Interim Report

Chapter 2: The need for reform in theUK banking sector

2.1 This chapter begins by considering what the fnancial system is or. It then examinessources o instability in banking, and explains how the nature o banks activities canmake them more ragile than other businesses. It briey considers the recent crisisrom a UK perspective, and discusses how the UK is particularly exposed to fnancialturbulence through having a fnancial sector that is large relative to its economy. Thisis ollowed by a general consideration o what needs to be done to make the bankingsystem saer.

2.2 The chapter also discusses competition in UK banking markets. It explains howcompetition has suered as a result o the fnancial crisis, with a particular ocus onthe markets or personal current accounts (PCAs), mortgages and banking services orsmall and medium-sized enterprises (SMEs).

2.3 This Interim Reportconsiders a range o reorm options to promote fnancial stability

and competition in UK banking. Each o these options will have dierent beneftsand costs, and the Commissions goal is to recommend reorms that strike the bestbalance between these benefts and costs. In order to assess these, a common rame oreerence is required and this chapter sets out an analytical ramework or this purpose.

What is the nancial system for?

2.4 The fnancial system supports the wider economy by:

providing payments systems;

providing deposit-taking acilities and a store-o-value system;

lending to households, businesses and governments; and

helping households and businesses to manage their risks and fnancial needsover time.

2.5 Each o these activities is explained in more detail below. Banks are central to allo them. But other fnancial institutions also play an important role. In particular,

insurance companies and pension unds hold the majority o UK household savings,provide unding or frms (including banks) and help households and businessesmanage their fnancial risks. In addition, other fnancial companies have taken on


20/214


Interim Report

many o the traditional unctions o banks. More detail on the role o non-banks in thefnancial system is discussed in Annex 2.

Payments systems

2.6 Over time banks have developed complex networks that enable them saely andeciently to transer unds between dierent bank accounts. A payments system isthe sharedpart o an end-to-end process that oers an account-based transer servicebetween two fnal customers and (usually) between two dierent banks. Paymentssystems sit at the heart o the banking system. Transers can occur between personalcustomers, between businesses, or between personal and business customers.Payments systems are vital to the UK economy, and disruption o a payments systemcould de-stabilise the fnancial markets and cause wider economic disruption.

Deposit-taking acilities and store-o-value system

2.7 The most visible unction that banks undertake is to receive deposits rom savers,including the general public. Households in the UK are the ultimate holders o wealthin the UK, yet they are not well placed to look ater that wealth saely themselves and

use it eectively. Furthermore, money that is not engaged in productive activity willdevalue over time as a consequence o ination. Interest-bearing deposit acilitiesthereore act to store value.

Lending

2.8 However, banks do not take deposits simply to provide saety or the savings o thepublic. They use unds that are deposited with them1 to provide loans to businesses toallow them to undertake productive economic activities, and also to consumers. Thebanks pay interest to depositors or the right to use their unds to make loans. They

make a proft by charging a higher rate o interest on loans than they pay on deposits.Getting access to loans is advantageous to borrowers and to the economy in general because capital is able to circulate, and be used in an ecient manner.

Managing risks and fnancial needs over time

2.9 Having access to banking acilities enables individuals and businesses to managetheir risks and fnancial needs over time. At its most basic, this involves providingbanks customers with access to both borrowing and saving acilities. Banks ability

to manage risk is also undamental to the value they add in other activities. Forexample, fnancial intermediation between retail depositors and business borrowers

1 Banks also have other sources o unding, such as borrowing in the capital markets.


21/214


Interim Report

is advantageous to depositors as it ensures that they can get a return on their deposit,without needing to have specialist knowledge o the borrowers or the variousactivities that loans may und. Banks also provide investment banking services suchas advisory services and acting as counterparties or client trades to companies andgovernments. Banks take on the management o the various risks such as creditrisk, liquidity risk and interest rate risk inherent in making and managing loans. Themanagement o risk goes to the very heart o banking.

Financial stability

Sources o instability in banking

2.10 Banks have a much higher ratio o debt to shareholders capital than non-fnancialfrms (see Box 1 below), and conduct maturity transormation by fnancing long-termassets with short-term liabilities. So a banks solvency can be threatened by a relativelysmall proportion o its assets going bad. And because o maturity mismatch betweenassets and liabilities, even a solvent bank can ail (in the absence o the provision oliquidity rom a lender-o-last-resort) i there is a large-scale withdrawal o depositsand other short-term unding.

2.11 In addition, banks tend to ail together, or a number o reasons. Banks are connectedto each other in important ways,2 so the ailure o one or more banks can directly harmothers. The collapse o one bank may cause one or more o its counterparties to ail,to the detriment o other banks with which the counterparties also have dealings.The rapid sale o assets by a bank suering stress may depress prices, triggeringlosses on marked-to-market assets or other fnancial institutions. Banks are otenexposed to similar risks, so i one banks assets are hit other banks are also likely toexperience problems. And all banks are vulnerable to a generalised lack o confdencein fnancial institutions that limits the availability o liquidity and unding. These areall maniestations o systemic risk the risk o signifcant disruption to the fnancialsystem as a whole, exacerbated by dependencies and interconnections between

fnancial institutions and markets. Without robust system design, the stability o thesystem can be susceptible to the ailure o just one component.

2 For example, through the interbank, repo and derivatives markets, and through payments systems.


22/214


Interim Report

Box 1: Banks and leverage

Banks use a lot more debt and a lot less equity to fnance their activities than other frms. Figure 2.1shows that UK banks were typically 20x leveraged rom 1960 to 2000 i.e. their assets (loans etc.)were twenty times bigger than the capital supplied by shareholders. This leverage ratio rose tonearly 50x as the crisis hit (although it has since allen back). Much o the increase was associatedwith the expansion o UK banks global investment banking activities in the 2000s.

Figure 2.1: UK banks leverage(a) (b)

0

10

20

30

40

50

60

70

1960 1970 1980 1990 2000 2010

Maximum-minimum range

Interquarle range

Median

Rao

Leverage has a multiplier eect on returns. In good years, such as the earlier 2000s, leveragemagnifes the private returns to banking. In bad years, however, it magnifes losses. With 20xleverage, a 5% all in the value o a banks assets would wipe out its equity value. With 50x leverage,even a 2% all would do this. In an eort to contain private incentives or leverage, minimum capitalrequirements began to be imposed on banks and these were harmonised in 1988 as part o theBasel Capital Accord. Capital had to be at least 8% orisk-weightedassets (RWAs). I, or example, theaverage risk weight or a banks assets was 50%, then this would allow leverage o 25x total assets.[1]

This constraint was still in place in the run-up to the crisis. But the average risk weight attributed toUK banks assets had roughly halved since 1988 to around 33% by 2008. [2] (With hindsight it wouldappear that as risk weights were decreasing, risk was in act mounting.) So the 8% minimum capitalratio translated to leverage o 35-40x in terms o total assets. And because some o this 8% was met

with non-equity orms o capital which proved unable to bear losses, real leverage was higher still.

This thin layer o capital proved insucient or many banks in the recent crisis. Holders o bankdebt should have been next in line to bear losses. In the event, however, due to the diculties oreorganising complex banks while keeping essential banking services running, this generally provedimpossible and taxpayers picked up the bill instead.

The recent Basel III reorms aim to make this structure less brittle. [3] But even i average risk weightsrise to 50% (rom around 33%) and banks hold truly loss-absorbing equity capital o 7% o RWAs, thiswould allow total assets to be almost 30x equity capital. And so banks could only withstand a 3.5%all in the value o their assets beore wiping out this capital.

[1] 8% o RWAs would be 4%, or 1/25th, o total assets.

[2] Ratio o RWAs to total assets or Barclays, HSBC, Lloyds Banking Group, RBS and Standard Chartered.

[3] See Box 3 in Chapter 3 or a summary o the Basel III reorms.

(a) Ratio o total assets to shareholders claims.

(b) The data are or a sample o institutions

providing banking services in the UK in 2009,

adjusted historically or mergers and acquisitions.

The sample includes the ollowing fnancial groups:

Barclays, Bradord & Bingley, HSBC, Lloyds Banking

Group, National Australia Bank, Nationwide,

Northern Rock, RBS and Santander UK. Where data

are consistently available or the UK component o

the banking group, these have been used.

Source: Bank of England, December 2010,

Financial Stability Report (updated, with

some restatements for 2009 data).


23/214


Interim Report

2.12 These undamental vulnerabilities are particularly important because o the dicultiesinvolved in dealing with ailing banks. The diculties are heightened or banks whichare large and/or complex, and or banks whose operations span several countries.Two o the main diculties are:

the bankruptcy process is greatly value-destroying for banks. Standard corporateinsolvency procedures involve reezing the claims o creditors while liquidatingassets and/or continuing to operate the business insoar as this maximises thevalue o the frm. But banks are dierent in that in order to continue to unctionthey need to maintain the confdence o their creditors (including depositors)and they risk suering losses on assets (such as loans) i they are orced tosell them beore maturity. The process o liquidating assets prematurely andreezing creditor claims thereore brings banking activities to a halt and destroyssignifcant value; and

bank failure imposes collateral damage. To a much greater degree than is typicalor other frms, the ailure o a bank can result in collateral damage or othersincluding its competitors, counterparties and other market participants. Even idepositors are protected by insurance, they will still be vulnerable to temporarylack o access to unds and to the disruption o payment arrangements.

2.13 Bank ailure can also aect the economy more widely i the bank is systemicallyimportant. The consequences o an interruption in the supply o fnancial services willvary depending on the nature o those services, and the proportion o the fnancialsystem that is aected. A major disruption to the retail payments system could havea catastrophic social and economic impact. And interruptions in the supply o banklending to borrowers with limited access to alternative sources o credit will constraininvestment, reducing both demand and supply capacity and hence GDP.

2.14 Accordingly, the ailure o a systemically important bank which provides criticalfnancial services and which is heavily connected to the rest o the fnancial systemand the wider economy has particularly high costs. Because not all o the costs o a

banks ailure are borne by its owners, creditors and managers, banks are likely to takeon more risk than is good or society as a whole, unless their structure and conduct iscareully regulated.

2.15 As a consequence o the high social cost o bank insolvency, governments haveoten elt compelled to provide capital as well as liquidity support to rescue bankson the brink o ailure (as happened in the recent crisis). I it is anticipated thatgovernments will bail out ailing banks particularly likely or banks that are seen assystemically important then such institutions operate with a government guarantee.A government cannot credibly commit in advance not to bail out a systemically

important bank, because should it ail in the uture, the costs o letting it collapse aregreater than the costs o a bail-out. Taxpayers underwrite risks or which the related


24/214


Interim Report

rewards are enjoyed by the private sector.3 This undercuts market discipline. As a resulto the government guarantee, creditors will be prepared to provide cheap unding toa systemically important bank that conducts risky activities, rather than constrainingsuch risk taking by demanding a higher return to compensate or the risks. This is notonly inequitable, but also urther incentivises excessive risk taking by banks.

2.16 As well as imposing direct costs on taxpayers, guarantees can also jeopardise thecreditworthiness o the state, raising borrowing costs or the government and thewider economy. This point is discussed in more detail in Paragraph 2.24 below.

The recent crisis rom a UK perspective

2.17 Reorms to fnancial regulation must not aim solely at addressing past crises. The nextcrisis will surely have dierent causes, and run a dierent course. The goal must be toimprove the resilience o the banking system to shocks regardless o the orm theytake. Nonetheless, it is useul to take a look at how the recent crisis unolded.

2.18 In the run-up to the recent crisis there was an explosion in bank leverage. This madebanks more vulnerable to losses. Triggered by a decline in US property prices, losseson securities backed by US subprime mortgages rom the summer o 2007 onwards

exacerbated by uncertainty as to which institutions were holding assets with unrealisedlosses caused a generalised withdrawal o liquidity. Interbank lending declined, andbanks ability to raise unds in the repo markets was hit as participants became moreworried about the price that collateral would achieve in a orced sale. Central banksinjected huge amounts o liquidity into the banking system in attempts to alleviatebanks liquidity problems although in the UK this did not save Northern Rock.4

2.19 Similar concerns also aected leveraged non-banks (which did not have access tocentral banks liquidity acilities), including hedge unds, insurers, securities dealersand structured investment vehicles (SIVs). Having long-term assets unded with short-term borrowings, leveraged institutions were vulnerable to re-fnancing risk. As the

crisis progressed and asset prices ell, these institutions suered what were eectivelyruns. Lenders demanded more or better quality collateral against loans. Unable tocomply, borrowers were orced to sell assets to repay their loans, urther depressingprices. The problem or many fnancial institutions was compounded by the act thatliquidity provision commitments and reputational concerns led them to bring o-balance sheet vehicles such as SIVs back on-balance sheet.

2.20 The combination o depressed asset prices and increasing losses on loans led toundamental solvency issues at a number o institutions, both banks and non-banks.In the US, Bear Stearns had to be rescued by JPMorgan (with US Government support)

in March 2008 and Lehman Brothers collapsed in September 2008. Unable to meet3 Annex 3 discusses the government guarantee o the UK banking system in more detail.4 Shin, H.S., 2008, Reections on Modern Bank Runs: A Case Study of Northern Rock: http://www.princeton.edu/~hsshin/www/nr.pd
http://www.princeton.edu/~hsshin/www/nr.pdfhttp://www.princeton.edu/~hsshin/www/nr.pdfhttp://www.princeton.edu/~hsshin/www/nr.pdfhttp://www.princeton.edu/~hsshin/www/nr.pdf


25/214


Interim Report

collateral requirements, AIG was bailed out by the US Government in September 2008.Royal Bank o Scotland (RBS) and Lloyds Banking Group (LBG) were bailed out by the UKGovernment in October 2008, and there were more government bail-outs in Europe.With alling asset prices, and troubled fnancial institutions cutting back on lending, thecrisis spread beyond the fnancial sector, and economies around the world were throwninto recession.

2.21 An important contributory actor to the need or and size o government bail-outs wasthat when losses hit, banks liability structures proved to be poor at absorbing them.In theory, losses all on unsecured liabilities in reverse order o seniority rom equity,through to subordinated debt, and then to senior debt and other unsecured creditors(with retail depositors protected to the extent provided or by deposit insuranceschemes). However, this order o loss absorption only works well in insolvency, whichthe government bail-outs prevented. Accordingly, in many banks that receivedgovernment bail-outs equity holders were not wiped out, holders o subordinateddebt took modest losses, i any, and senior debt holders generally came out whole.

2.22 The crisis represented a spectacular ailure by fnancial institutions and the market tomanage risk eciently. They amplifed, rather than absorbed, the shock rom the allin property prices. A (severe) correction in asset prices was transormed into a globaleconomic crisis.

2.23 The UK was severely aected by the crisis. National output in 2010 was 4.5% belowits pre-recession peak.5 Unemployment has risen by more than 800,000 since 2007.6The public fnances have deteriorated sharply, and the 2009/10 defcit exceeded 10%o GDP.7 There is evidence to suggest that some o the output loss economies suerduring crises is permanent. Work by the Basel Committee on Banking Supervision(BCBS) suggests that the cost o banking crises may exceed 60% o pre-crisis GDP.8More than 80% o RBS and more than 40% o LBG are in state ownership as a result othe Government bail-out o the banking system.9 Competition in UK banking has beenseriously weakened as rivals to the largest retail banks have let the market or beenabsorbed into others.

5 Bank o England, Ination Report, February 2011: http://www.bankoengland.co.uk/publications/inationreport/ir11eb.pd6 Unemployment was more than 800,000 higher in January 2011 than in January 2007: Oce or NationalStatistics, Statistical Bulletin: Labour Market, March 2011 and March 2007.7 Oce or National Statistics, Statistical Bulletin: Public sector nances, January 2011

8 BCBS, 2010, An assessment of the long-term economic impact of stronger capital and liquidity requirements: http://www.bis.org/publ/bcbs173.pd9 UK Financial Investments, 2010, Update on UKFI Market Investments: http://www.ukf.co.uk/releases/115_2%20FW%20Update%20Jan%202010_10_AW_LR.pd. The Government has invested approximately 65bn in RBS andLBG.
http://www.bankofengland.co.uk/publications/inflationreport/ir11feb.pdfhttp://www.bankofengland.co.uk/publications/inflationreport/ir11feb.pdfhttp://www.bis.org/publ/bcbs173.pdfhttp://www.bis.org/publ/bcbs173.pdfhttp://www.bis.org/publ/bcbs173.pdfhttp://www.ukfi.co.uk/releases/115_2%20FW%20Update%20Jan%202010_10_AW_LR.pdfhttp://www.ukfi.co.uk/releases/115_2%20FW%20Update%20Jan%202010_10_AW_LR.pdfhttp://www.ukfi.co.uk/releases/115_2%20FW%20Update%20Jan%202010_10_AW_LR.pdfhttp://www.ukfi.co.uk/releases/115_2%20FW%20Update%20Jan%202010_10_AW_LR.pdfhttp://www.ukfi.co.uk/releases/115_2%20FW%20Update%20Jan%202010_10_AW_LR.pdfhttp://www.bis.org/publ/bcbs173.pdfhttp://www.bis.org/publ/bcbs173.pdfhttp://www.bankofengland.co.uk/publications/inflationreport/ir11feb.pdfhttp://www.bankofengland.co.uk/publications/inflationreport/ir11feb.pdf


26/214


Interim Report

Figure 2.2: Domestic banking assets as a percentage of GDP consolidated bynationality of headquarters (2009)10

0

100

200

300

400

500

PercentofGDP

Source: ECB, Eurostat, published accounts, national sources, IMF, Commission calculations

2.24 Despite recent de-leveraging, the total balance sheet o UK banks is large byinternational standards, more than our times annual GDP (see Figure 2.2). Asthe diculties being experienced by Ireland illustrate, a large banking sector canrepresent a real threat to the public fnances.11 Figure 2.3 below shows how Irish bankcredit deault swap (CDS) spreads initially tightened when the guarantee o theirliabilities was announced in 2008, but at the expense o the sovereign. There was asimilar pattern in the UK at the announcement o the bank rescue package in October2008 (see Figure 2.3). Had the asset quality o UK banks turned out to be as bad as thatin Ireland, the hit to the UKs fscal position would have been signifcantly worse thanit was. I the public fnances become unable to bear the costs o bailing out a ailing

banking system, the too big to ail problem becomes a too big to save problem,risking the collapse o the provision o fnancial services and/or a collapse in theperceived creditworthiness o the public fnances.

10 EU data are consolidated domestic banking assets rom the ECB, and GDP rom Eurostat. Australia, Japan andSwitzerland banking data rom national sources. US data are or the 30 largest banking groups, rom company

accounts. Non-EU GDP data are sourced rom Datastream. Domestic banking assets are the global assets o allbanks whose global headquarters are located in the relevant country.11 In the case o Ireland, this culminated in the announcement o an external assistance package worth 67.5bnunded by the European Financial Stability Mechanism, the IMF, the European Financial Stability Facility andbilateral loans.


27/214


Interim Report

Box 2: Credit default swaps

Credit deault swaps (CDS) are a orm o insurance against loss on a debt contract. The price (orspread or premium) on a CDS is a measure o how likely and severe the market expects deault onthe underlying contract to be.

Bank CDS spreads rose during 2008, and rose particularly sharply ater the bankruptcy o LehmanBrothers on 15 September 2008 as markets became more concerned about the quality o bankassets. Bank CDS spreads ell back again in the UK and Ireland as government support measuresor banks were announced. But the price o insuring against the deault o those governmentsdebt rose at the same time. This is consistent with the markets taking into account an increasedprobability o a sovereign debt crisis caused by the costs o bailing out banks.

As the picture or Irish banks worsened throughout 2009-10, the cost to the Irish Governmento the guarantee increased, and Irish sovereign CDS spreads rose urther. Market perceptions oUK banks stabilised throughout 2009-10, limiting the contagion to sovereign creditworthiness.However, the initial market reaction in 2008 and the experience o Ireland suggests that, had theposition o UK banks been worse, they may have been big enough to cause a UK sovereign debtcrisis. And UK Government CDS spreads remain much higher than they were beore 2008.

Figure 2.3: Irish sovereign vs Irish bank CDS spreads and UK sovereign vs UKbank CDS spreads

0

100

200

300

400

500

600

700

J an -08 Jul-08 Jan- 09 Jul-09 Jan -10 Jul-10

Irish

Government

Avg of BoI and

AIB

bps

Source: Datastream, Commission calculations. BoI is Bank of Ireland, AIB is Allied Irish Bank. UK Big 4

are Barclays, HSBC, LBG and RBS.

2.25 As well as being high in aggregate relative to GDP, UK banking assets areconcentrated in a small number o institutions, the our biggest o which each operatea major UK retail banking network. The ailure o even one such institution could

thereore represent a potential threat to the public fnances. This risk is not uniqueto the UK, but it is more severe or the UK than or many other countries. By way o

0

50

100

150

200

250

Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10

UK Government

Avg of UK Big 4

bps


28/214


Interim Report

example, Citigroups total assets amounted to 16% o US GDP12 at the time it had tobe bailed out by the US Government. The comparable fgure or RBS at the time o itsbail-out was 99% o UK GDP,13 including a considerable volume o non-UK assets.

Making the banking system saer

2.26 What needs to be done to make the UK banking system saer? The probability and sizeo macroeconomic shocks need to be reduced. But better macroeconomic includingmacro-prudential policy, while important, will never be able to eliminate shocksaltogether (particularly global shocks). So measures are also required to increase theresilience o UK banks and so reduce the probability that a shock will trigger bankailures. Andmeasures are needed to protect the economy, and the taxpayer, romsignifcant harm, by reducing the impact o bank ailures that do occur.

2.27 While banks do need to become better able to withstand losses, reducing theprobability o bank ailure does not require all banks to be prevented rom ailing inall circumstances. Indeed, the possibility o idiosyncratic bank ailure is a necessaryconstituent o healthy competition. But any bank ailure needs to be orderly, so as tominimise the costs to others.

2.28 In the recent crisis, when a systemically important bank neared the point o ailure,the government was aced with a choice. It could allow the bank to go insolvent, orit could bail it out. As discussed above, allowing a systemically important bank tocollapse into insolvency brings huge social costs so in the crisis these banks werebailed out. What is required is an alternative that allows a ailing bank to be sorted out or resolved in a way that avoids both signifcant costs to the rest o the economy,and the need or a government bail-out. Much o the negative impact on societyo the insolvency o a systemically important bank stems rom interruptions in thecontinuous provision o essential banking services. So a successul resolution o sucha bank needs to keep any such interruptions to a minimum.

2.29 The ways in which an interruption in the provision o banking activities resultingrom bank ailure may have a negative impact on the fnancial system and the widereconomy will vary with the size and nature o the bank, but may include:

a disruption to the payments system;

depositors being unable to access unds;

poorer availability and/or pricing o credit (including the re-fnancing o existingloans);

12 Commission analysis, based on US GDP numbers rom the World Banks World Indicators and Citigroups 2008Annual Report.

13 Commission analysis, based on UK GDP numbers rom the Oce o National Statistics and RBSs 2008 AnnualReport, adjusted to show assets under US GAAP defnitions to allow comparison.


29/214


Interim Report

disruption to clients ability to access assets placed with a ailed bank, and to theprovision o investment banking trading and advisory services; and

contagion to other fnancial institutions and to the wholesale unding markets,both through direct exposure to the ailed frm and through a generalisedcollapse in confdence in fnancial institutions.

2.30 It is important that authorities are provided with a comprehensive set o resolutiontools to improve their ability to manage the ailure o banks.14 But in order to avoid aninterruption to the conduct o key banking operations in resolution, those operationsneed to have access to adequate capital and liquidity resources. In resolution,certainly in the short term, the most credible alternative to the taxpayer as a sourceo new capital is likely to be the imposition o losses on existing holders o liabilities.And the liquidity insurance provided by the central bank to solvent, creditworthyinstitutions is also likely to be called upon.15

2.31 Even where the authorities have a broad range o resolution powers, there are stillchallenges and risks associated with the ailure and resolution o a systemicallyimportant bank. Putting such a bank into resolution is likely to involve the regulatoryauthorities exercising their judgement in coming to a decision which eectivelywrests the bank away rom the existing shareholders, and may involve the imposition

o losses on creditors. Even in a situation where a solvent wind-down is ultimatelyachieved, the decision to put the bank into resolution in particular i the positionis fnely balanced may unsettle markets. This could make it more dicult or otherbanks to access the wholesale unding markets; some institutions may be shut outaltogether.

2.32 Any reorm proposal that limits the spillovers rom bank ailure will reduce systemicrisk, and so lessen the chance that a bank ailure threatens the fnancial system as awhole. But reorms that stabilise the UK banking system may also raise its costs. Thismay cause some activities to move to non-banks, oreign banks, or capital markets.This shit in activity may create fnancial instability, by acilitating excessively rapid

growth in credit and asset prices in good times or, in times o stress, by non-bankinstitutions withdrawing too quickly, shiting losses onto the banks, or requiringliquidity rom them. This was the case with some non-banks in the recent crisis.

2.33 But these alternative providers may be able to conduct business without generatinginstability elsewhere in the fnancial system. For example, many hedge undscollapsed in the recent crisis, and yet in general their ailure did not cause majorsystemic problems. While in the run-up to the recent crisis some fnancial activities

14 The Banking Act 2009 creates a Special Resolution Regime which gives the UK authorities a permanentramework providing tools or dealing with distressed banks and building societies.15 See Rochet & Vives (2011) or a rationale or helping illiquid but solvent banks (Rochet, J. & Vives, X., 2011,Coordination Failures and the Lender o Last Resort: Was Bagehot Right Ater All?, in Allen, F., Carletti, E., Krahnen,J.P. & Tyrell, M., 2011, Liquidity and Crises, Oxord, Oxord University Press).


30/214


Interim Report

were conducted in the shadow banking16 sector simply to avoid bank regulatoryrequirements, this is not invariably the case. Non-banks may well be better-placedthan banks to conduct some fnancial activities, and limiting the implicit governmentguarantee or banks may also encourage some activities to move out o the bankingsystem. To the extent that shadow banks can saely remove risk rom the bankingsystem, an increased role or them will be positive or fnancial stability.

2.34 So the migration o activities between banks and non-banks can have mixedconsequences. More generally, fnancial innovation and reorm o banking regulationwill cause the fnancial system to evolve in unpredictable ways. The advent o theFinancial Policy Committee o the Bank o England is crucial in this regard. TheCommittee will have tools designed to moderate credit and asset prices, and to bringnon-banks within the regulatory perimeter. Proposals to standardise over-the-counter(OTC) derivatives where possible, and clear them through a central counterparty,will also help contain systemic risk by strengthening market inrastructure acrossthe fnancial system as a whole. However, the prospect o tighter regulation shitingactivity outside o the banking system is nonetheless a key consideration or theCommission. Annex 2 provides more detail on this issue.

2.35 In brie, reorms are needed:

to reduce the probability o ailure o systemically important banks by improvingtheir resilience; and

to reduce the impact o ailure o systemically important banks, both byproviding or the orderly resolution o any institutions that ail, and by reducinglevels o risk in the fnancial system as a whole,

without disproportionately aecting the fnancial systems ability to provide criticalfnancial services. The Commissions proposals or reorm options to promote fnancialstability are set out in Chapter 4 o this Interim Report.

Competition

2.36 Many studies and competition investigations in recent years have looked intocompetition in retail banking services, in the UK and other countries. These haveidentifed a number o actors that aect competition in retail banking, includingconcentration, barriers to entry, regulation, ability to compare products, switchingcosts, and other inormational problems. In many markets, including the UK, problemshave been ound in a number o these areas that inhibit eective competition inretail banking, and a range o measures have been introduced by the competition

authorities to attempt to address these.17

16 Shadow banks are non-banks that conduct banking-type activities17 See or example, OFT, 2008, Personal current accounts in the UK: http://www.ot.gov.uk/shared_ot/reports/fnancial_products/OFT1005.pd.
http://www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdfhttp://www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdfhttp://www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdfhttp://www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdfhttp://www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdf


31/214


Interim Report

2.37 Some progress was made in the UK over the past decade, due in part to the eortso the competition authorities, but also through the activities o challenger banks those that are large enough to be a threat to the incumbents, but small enough tohave a strong incentive to compete to increase their market share. These challengersseem to have played an important role in stimulating competition in a number oretail banking markets. The fnancial crisis has reversed some o the gains o the pastdecade, most notably by leading to a signifcant increase in concentration in retailbanking markets, and by reducing the number o challengers. The Commission hasconsidered the extent to which the fnancial crisis has aected these markets, takingull account o the extensive work already conducted by the competition authorities.In doing so, it has investigated the other key actors determining market competition,to see i market orces could remedy the eects o the crisis.

2.38 This section provides an overview o the current state o competition in UK bankingmarkets. It considers their structure over the past decade and the extent to which theyhave been aected by the crisis, the nature o the relationship between concentrationand competition, and other actors aecting competition in retail banking, includingthe important role o challengers.

2.39 Much o the market inormation made available to the Commission is proprietarydata, and as such has been included in this Interim Reportonly in summary orm.

Concentration in UK banking markets

2.40 The fnancial crisis led to a signifcant increase in the concentration o UK bankingmarkets.18 Some small and medium-sized banks let the market through ailure,merger or (in the case o some oreign banks) withdrawal. The reductions inconcentration across the majority o markets in the years preceding the crisis werereversed. As Figure 2.4 shows, levels o concentration rose to their highest points in adecade or more.

18 The Commission has considered separately the markets or PCAs, savings accounts, mortgages, credit cards,personal loans, and SME banking services. In general, the Commission has assumed markets to be UK-wide.

The great majority o retail banking products are available to customers across the UK without any dierence incharacteristics or prices and a number o large banks have national branch networks that make the same productsavailable across the country (source: Deaqto). The Commission has considered separate markets to enable acomplete economic analysis, rather than conducting a ull relevant market defnition exercise or the purposes ocompetition law.


32/214


Interim Report

Figure 2.4: Concentration levels in personal and SME banking measured usingthe Herndahl-Hirschman Index19

1470

1290

1830

930

800

12601150

1010

1220

660

1620

1130

820

1040

1730

500

700

900

1100

1300

1500

1700

1900

2100

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

H

HI

Main personal current accounts Personal mortgages Personal savings

Personal loans Personal credit cards SME banking (turnover up to 1m)

1950

1690

Source: Commission analysis of SME banking data from the Competition Commission (2000) and TNS

(2005-2009), and personal banking data from GfK FRS.i (Roman numerals refer to endnotes at the end

of the chapter.)

2.41 Competition led to a gradual but steady decrease in concentration o the PCA marketbeore the crisis. In general, brands with consistently the highest level o customerservice,ii or better interest rates, have grown only slowly. As aggregate groups,challengers have achieved some organic growth, though smaller banks have not. The

PCA market is now particularly concentrated ollowing a jump in concentration asa result o the crisis, as Figure 2.4 shows. In 2010, the fve largest banks had an 87%share o the market.iii

2.42 The market or SME banking services is more concentrated than any o the personalbanking markets, with fve banking groups holding over 90% o the market in 2009.

19 The Herfndahl-Hirschman Index (HHI) is a measure o market concentration. Higher numbers indicate moreconcentrated markets. See the Glossary or urther details. Main personal current accounts are those that surveyrespondents holding more than one current account indicated was their main account. From TNS, market shares(by number o customers) or SMEs with a turnover o up to 1 million were used as these were available or the

longest time period. Where market shares were also available or larger businesses, these were similar to theshares or this sub-section. The TNS RI Small Business Banking Survey data uses respondents subjective opinion oa defnition based on main bank. In the view o at least one bank this has a potentially misleading eect on anysubsequent assessment, analysis and calculations o the SME market based on the data. 2009 and 2010 data doesnot include the RBS and LBG divestitures discussed later (see Chapter 5).


33/214


Interim Report

The market has been concentrated or at least the past decade. Very ew new entrantsor challengers have succeeded in gaining signifcant market share.20

2.43 A number o new frms (including oreign banks) entered the mortgage market overthe past decade, though many have since exited, and it may be more dicult to enterin the coming years due to more dicult unding conditions and stricter regulation.The market is currently concentrated, and signifcantly more concentrated than at anytime since at least the year 2000.iv

2.44 The savings market is less concentrated and more contestable, and market sharesshow more organic change than or PCAs. The credit card market the supply ocredit card services to personal consumers rather than to retailers is not particularlyconcentrated. There has been signifcant entry and exit, and changes in market shareover time. The personal loan market has become more concentrated over time, withthe fve biggest banking groups expanding their market share rom under 50% in2000 to over 75% in 2010. However, the personal loan market is still only moderatelyconcentrated, and some small players have been able to increase their market share.These three markets savings, credit cards and personal loans appear to be morecontestable than the PCA, SME banking and mortgage markets. v

2.45 Four banking groups have had signifcant market shares in all o the fve personal

banking markets mentioned above, as well as SME banking, throughout the lastdecade.vi These banks RBS, HSBC, Barclays and Lloyds TSB (or LBG since 2009) arereerred to as the Big Four banks. Following Lloyds TSBs merger with HBOS in 2009,in 2010 LBG had a signifcantly greater market share in all o these fve personalbanking markets than any other bank.21 (The state aid divestitures by LBG and RBS andtheir eect on levels o concentration are discussed in Chapter 5.)

2.46 Some markets are signifcantly more concentrated in parts o the UK. For example, theSME banking market appears to be more concentrated in Scotland than in the resto the UK and the market in Northern Ireland is complicated by the fnancial stabilityproblems o the Irish-owned banks. The Commission does not currently intend to

make region-specifc recommendations, but it is mindul o specifc regional issuesand impacts, and would welcome urther evidence on this subject.

2.47 The UK appears to be similar to many other developed countries, such as theNetherlands, Sweden, Australia and Canada, in having a concentrated retail bankingmarket. However, it is dicult to compare across countries as their histories andcompetitive dynamics dier (or example, in some countries regional banks are

20 Based on Commission analysis o data provided by TNS RI Small Business Banking Survey in Great Britain, orbusinesses with a turnover


34/214


Interim Report

the norm), and there are ew comparators with a similar population to the UK, andnational (as opposed to regional) bank networks. In any case, the act that there areother examples o concentrated markets does not suggest that there are no problemswith competition. Governments or regulators in other countries (or example,Australia and the Netherlands) have recently investigated aspects o retail bankingcompetition in their own markets, or are acting to reduce market concentration: inthe US, the Dodd-Frank reorms prohibit a fnancial company rom merging with oracquiring another frm, i the result is a company with over 10% o the aggregateconsolidated liabilities o all frms in the domestic market.22

Does concentration matter?

2.48 Market power that is, the ability to set prices above the costs incurred in supplyinga banking service can arise due to markets being concentrated, and/or individualbanks being large (in practice, these two actors are likely to occur together). In itssimplest orm, a market with a small number o large banks would be expected tohave prices set higher than the costs o supply, even without active collusion betweenthe banks. An alternative explanation is that only large banks can inuence pricingand raise profts in this case, it would be large banks that charge higher prices, ratherthan more concentrated markets having higher prices throughout.

2.49 Market power can also come rom customers being unable or unwilling to switch. Ina market where only a small proportion o customers switch and banks charge thesame price to all their customers, banks can choose between setting high prices tomaximise the profts they make rom their existing customers, or setting low prices toattract switchers.23

2.50 For a small bank, setting a low price to attract switchers is more worthwhile than orlarger banks since small banks can gain a greater proportion o their total customersby oering good deals.24 In addition, smaller banks lose less money on their existingcustomers by oering good deals as the existing customers are a smaller proportion

o the existing and new customers together.

2.51 Annex 4 summarises a number o studies that have investigated how concentration inbanking markets aects competition and the prices that consumers pay. In practice, itdoes appear to be the case that banks in more concentrated markets tend to charge

22 See Section 622 o the Dodd-Frank Act, analysed in depth here: http://www.treasury.gov/initiatives/Documents/Study%20on%20Concentration%20Limits%20on%20Large%20Firms%2001-17-11.pd.23 This is premised on the assumption that banks are unable to charge dierent prices to new versus existingcustomers. In many cases, banks are able to dierentiate charges to a certain extent across groups o customers.

However, they cannot do this perectly, and their ability to do so varies across banks and products. Thereore this islikely to explain some o the pricing behaviour seen in banking markets. Price discrimination is considered urtherbelow.24 This argument is made in OFT, 2008, Anticipated acquisition by Lloyds TSB plc of HBOS plc: http://www.ot.gov.uk/shared_ot/press_release_attachments/LLloydstsb.pd.
http://www.treasury.gov/initiatives/Documents/Study%20on%20Concentration%20Limits%20on%20Large%20Firms%2001-17-11.pdfhttp://www.treasury.gov/initiatives/Documents/Study%20on%20Concentration%20Limits%20on%20Large%20Firms%2001-17-11.pdfhttp://www.treasury.gov/initiatives/Documents/Study%20on%20Concentration%20Limits%20on%20Large%20Firms%2001-17-11.pdfhttp://www.oft.gov.uk/shared_oft/press_release_attachments/LLloydstsb.pdfhttp://www.oft.gov.uk/shared_oft/press_release_attachments/LLloydstsb.pdfhttp://www.oft.gov.uk/shared_oft/press_release_attachments/LLloydstsb.pdfhttp://www.oft.gov.uk/shared_oft/press_release_attachments/LLloydstsb.pdfhttp://www.oft.gov.uk/shared_oft/press_release_attachments/LLloydstsb.pdfhttp://www.treasury.gov/initiatives/Documents/Study%20on%20Concentration%20Limits%20on%20Large%20Firms%2001-17-11.pdfhttp://www.treasury.gov/initiatives/Documents/Study%20on%20Concentration%20Limits%20on%20Large%20Firms%2001-17-11.pdf


35/214


Interim Report

higher prices (i.e. pay less interest on deposits and/or charge more interest on loans).25However, the results can vary, particularly across countries, since many other actorscan also aect competition and the prices that consumers pay. In analysis lookingspecifcally at the UK market, the two most relevant studies both show that in mostcases greater concentration led to higher prices.26

2.52 As market power insulates banks rom competition, banks thereore have lessincentive to innovate and become more ecient, which would lead to lower costsand improved products or customers. In the long run, higher costs due to reducedpressure to raise eciency may have a greater impact on the economy than theongoing higher prices or customers.

Barriers to entry

2.53 The Oce o Fair Trading (OFT) reported recently on barriers to entry in retail banking,and ound that new entrants ace signifcant challenges in attracting customersand expanding their market shares.27 The greatest barriers came rom the dicultyin attracting personal and SME customers, due to customers preerence or bankswith an extensive branch network, strong brand loyalty and low switching rates.These barriers can have the eect o deterring frms rom entering the market in the

frst place, i they do not believe they will be able to attract sucient numbers ocustomers to recover start-up costs, grow market share and maintain a successulpresence in the market. Table 2.1 provides a summary o the OFTs conclusions on thebarriers to entry in retail banking.

25 For example, one review o a number o other studies fnds that: Market concentration ... results in signifcantspreads in both deposit and loan markets. See page 540, Degryse, H. & Ongena, S., 2008, Competition andRegulation in the Banking Sector: A Review o the Empirical Evidence on the Sources o Bank Rents, in Thakor, A. V.& Boot, A., eds., Handbook of Financial Intermediation and Banking, Amsterdam, Elsevier.

26 Heernan, S. & Fu, X., 2009, The structure o retail markets: what do we learn rom bank-specifc rates?, AppliedFinancial Economics and Gondat-Larralde, C. & Nier, E., 2006, Switching costs in the market or personal currentaccounts: some evidence or the United Kingdom, Bank of England Working Paper27 OFT, 2010, Review of barriers to entry, expansion and exit in retail banking: http://www.ot.gov.uk/shared_ot/personal-current-accounts/ot1282
http://www.oft.gov.uk/shared_oft/personal-current-accounts/oft1282http://www.oft.gov.uk/shared_oft/personal-current-accounts/oft1282http://www.oft.gov.uk/shared_oft/personal-current-accounts/oft1282http://www.oft.gov.uk/shared_oft/personal-current-accounts/oft1282


36/214


Interim Report

Table 2.1: OFTs conclusions on barriers to entry

IssuePotential barrier

investigatedOFT conclusion

Regulatoryrequirements

FSA authorisationrequirements

Not identied as a barrier/no evidence received.

FSA authorisationprocess

Noted as a barrier in the past by some rms due tolength and uncertainty of process; initiatives havenow been put in place to improve this (although it

is too early to say how eective they are).

OFT Consumer CreditLicence

Not identied as a barrier/no evidence received.

FSA capital and liquidityrequirements

Potentially high barrier for new entrants andsmaller rms due to high capital requirements

relative to incumbents. New capital and liquidityrequirements could exacerbate or reduce these

barriers.

Consumer protectionand money laundering

complianceNot identied as a barrier/no evidence received.

Access toessential inputs

Implementation of ITsystems

While a high sunk cost at start-up, the costs of

IT systems only become a barrier if rms believethey will be unable to attract enough customers torecover these costs in the future.

Access to paymentssystems (e.g. CHAPS &

Bacs)

Barriers may exist for certain unconventionalbusiness models, but no evidence received to

suggest there are signicant or widespread barriersto access.

Customer informationaccess

Not a signicant barrier for personal banking (manyinformation providers); however, banks can nd

it more dicult to source nancial information onsmall enterprises in order to price SME banking

products accurately.

Access to funds tonance expansion

Post-crisis, limited access to interbank funding andfew alternative funding sources can pose a barrierto expansion for certain rms, especially monoline

credit providers.

Ability to attractcustomers and

reach scale

Levels of switching inpersonal and business

current account markets

Low levels of switching make it dicult to attractcustomers.

Brand loyalty

A signicant barrier to expansion, as consumersare often wary of switching to unfamiliar brands,

perhaps in particular in Scotland and NorthernIreland.

Branch network

A signicant barrier to expansion, especially forPCAs/business current accounts (both gateway

products). Alternative distribution channels remaincomplements not substitutes.


37/214


Interim Report

2.54 Based on evidence o entry over the past decade, the credit card and personal loanmarkets appear the most contestable, with evidence o some new entry. These are themarkets with the greatest number o providers, and also a high number o entrantsover the past decade compared to the size o the market. There were also some newentrants into the markets or mortgages and savings accounts, though entry intothese markets has dropped o since the crisis, perhaps as a response to the economicenvironment and/or increased regulatory requirements. Many o the entrants intothe credit card, loan and mortgage markets have provided only a small number oproducts (rather than the ull range o personal banking products), and typically, theseproviders have captured only a small share o the market. vii

2.55 There have been very ew new entrants into the PCA market: just six over the pastdecade, o which only our maintained a presence in the market or more than oneyear. Those that survived have ailed to take a signifcant share o the market.viii Othe our potential challengers in SME banking over the past decade, only two havesucceeded in gaining signifcant market share. Other new entrants into SME bankinghave not (yet) gained substantial market share.ix

2.56 The UK retail banking market is readily open to entry by other banks rom within theEuropean Economic Area, and rom urther afeld. In some markets, this has increasedthe number o bank service providers. In addition, certain frms in other industries

may also be able to oer substitutes or bank services, or example, trade credit frmsproviding fnance to SMEs. However, in general, there are ew substitutes or manyretail banking services.

Switching and choosing providers

2.57 Three conditions must be satisfed in order or the threat o consumer switching toapply pressure on banks to improve their products and services: a better product toswitch to must exist somewhere in the market; the consumer must be able to identiythat product and the beneft o switching; and the consumer must be able to switch

easily and without risk.

2.58 Competition between banks is blunted by the actual and perceived diculties orcustomers switching accounts, and by poor conditions or consumer choice moregenerally. In its market study o PCAs in 2008, the OFT ound that without consumersbeing willing to switch between competitors, banks have little incentive to providebetter oers. The study ound that a signifcant proportion o consumers believe thatit is complex and risky to switch accounts, with the result that switching rates are verylow. Few consumers actively monitor the relative competitiveness o their accounts.It also ound that many consumers are not amiliar with the key ees associated with

their PCA, and that they have diculty understanding and calculating these ees.28

28 OFT, 2008, Personal current accounts in the UK: http://www.ot.gov.uk/shared_ot/reports/fnancial_products/OFT1005.pd
http://www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdfhttp://www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdfhttp://www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdfhttp://www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdfhttp://www.oft.gov.uk/shared_oft/reports/financial_products/OFT1005.pdf


38/214


Interim Report

Figure 2.5: Annual switching rates

0%

2%

4%

6%

8%

10%

12%

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Percentageofsu

rveyrespondentswhoswitched

accountin

theprevious12months

Main personal current accounts Credit cards

Savings Mortgages

SME main banking relationship

Source: Commission analysis of data provided by GFK FRS and TNS.x

2.59 Figure 2.5 shows that annual switching rates are low or banking products.29 Switchingrates are also low relative to other markets. For example, Ogem recently reportedthat during 2010, 15% o consumers reported switching their gas supplier and 17%reported switching their electricity supplier.30 Consumer Focus also conducted asurvey in 2010 comparing switching rates across industries, and ound that only 7% orespondents had switched current accounts in the past two years, compared to 31%who had switched energy provider, 26% who had switched telephone provider, and22% who had switched insurance provider.31

2.60 Within banking products, mortgages had the highest switching rates, peaking at just

over 10% in the middle o the last decade. However, over the past two years mortgageswitching rates have been much lower, which is likely a reection o low base ratesmaking standard variable rate mortgages attractive, but which may also indicate aworsening o competitive conditions in the mortgage market. PCAs and SME banking

29 Here, switching in personal banking markets is defned as those customers who reported that they hadswitched their account in the past 12 months or that they had opened an additional account with a dierentbrand. It also includes switchers between brands o the same banking groups. Thereore, it is likely to overstatethe total amount o switching (in the sense o opening a new account and closing an old account), but it presentsa better picture o the amount o shopping around by consumers. In SME banking, switching reers to surveyrespondents who reported that they had changed their main relationship bank within the past 12 months. Thisdoes not include the case where an SME has started an additional relationship with a dierent bank, and hence

may underestimate the amount o shopping around.30 Ogem, 2011, The Retail Market Review Finding and initial proposals: http://www.ogem.gov.uk/Markets/RetMkts/rmr/Documents1/RMR_FINAL.pd31 Consumer Focus, 2010, Stick or twist: http://www.consumerocus.org.uk/assets/1/fles/2010/10/Stick-or-twist-or-web.pd
http://www.ofgem.gov.uk/Markets/RetMkts/rmr/Documents1/RMR_FINAL.pdfhttp://www.ofgem.gov.uk/Markets/RetMkts/rmr/Documents1/RMR_FINAL.pdfhttp://www.consumerfocus.org.uk/assets/1/files/2010/10/Stick-or-twist-for-web.pdfhttp://www.consumerfocus.org.uk/assets/1/files/2