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

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1 The supply of banking services by clearing banks to small and medium-sized enterprises A report on the supply of banking services by clearing banks to small and medium-sized enterprises within the UK Volume 3: Background Chapters 8 13

2 COMPETITION COMMISSION The supply of banking services by clearing banks to small and mediumsized enterprises A report on the supply of banking services by clearing banks to small and medium-sized enterprises within the UK Volume 3: Background Chapters 8-13 Presented to Parliament by the Secretary of State for Trade and Industry and the Chancellor of the Exchequer by Command of Her Majesty March 2002

3 Competition Commission 2002 Web site:

4 Volume 3 contents Page Chapter 8 Views of third parties Views of smaller clearing banks Views of Barclays Views of HSBC Views of Lloyds TSB Views of RBSG List of signatories iii

5 Note by the Department of Trade and Industry In accordance with section 83(3) and (3A) of the Fair Trading Act 1973, the Secretary of State and the Chancellor have excluded from the copies of the report, as laid before Parliament and as published, certain matters, publication of which appears to the Secretary of State and the Chancellor to be against the public interest, or which they consider would not be in the public interest to disclose and which, in their opinion, would seriously and prejudicially affect certain interests. The omissions are indicated by a note in the text or, where space does not permit, by the symbol. iv

6 8 Views of third parties Contents Page Introduction... 4 Regulatory authorities... 4 Bank of England... 4 Hypothetical remedies... 7 Financial Services Authority... 8 Banking Review Team... 8 Profitability The market and competition Possible remedies Other banks Airdrie Savings Bank Bank of Cyprus (London) Ltd Crédit Lyonnais (UK) Halifax plc C Hoare & Co Lazard Bank Limited Northern Rock plc Robert Fleming & Co Limited Standard Life Bank Sun Bank PLC Tesco Personal Finance Limited Triodos Bank NV Whiteaway Laidlaw Bank Limited Woolwich plc Building societies The Chesham Building Society Derbyshire Building Society Furness Building Society Kent Reliance Building Society The Mansfield Building Society Monmouthshire Building Society Newbury Building Society Newcastle Building Society Norwich and Peterborough Building Society A building society Other financial organizations Association for Payment Clearing Services Anglia Business Associates Ltd Bibby Group of Factors Limited Close Invoice Finance Limited Earthport plc Five Arrows Commercial Finance Limited GMAC Commercial Credit Limited The Post Office RDM Factors Limited Visa International Service Association

7 Chambers of Commerce Ashford (Kent) Chamber of Commerce, Industry & Enterprise Bolton & Bury Chamber of Commerce British Chambers of Commerce Hypothetical remedies Dorset Chamber of Commerce & Industry...34 Dover & District Chamber of Commerce & Industry Mid Yorkshire Chamber of Commerce & Industry Limited Northamptonshire Chamber of Commerce Oldham Chamber of Commerce, Training & Enterprise Trade associations, SME representatives and advisory bodies Association of Convenience Stores Ltd Remedies Possible regulation of charges, terms, conditions or profits Behavioural remedies to remove barriers to entry Behavioural remedies to safeguard SMEs in their relationship with banks A possible tax, licence fee or fund Possible structural remedies Bank Mediation Services Brandenburg Securities Ltd British Bankers Association Possible regulation of charges, terms, conditions or profits Possible behavioural remedies primarily to remove barriers to entry Possible behavioural remedies primarily to safeguard SMEs in their relationships with their banks A possible tax, licence fee or fund British Cheque Cashers Association British Retail Consortium Business Link Isle of Wight Limited Business Link Sussex Ltd The Campaign for Community Banking Services Possible remedies Factors & Discounters Association Federation of Small Businesses Global Consulting (UK) Ltd Independent Banking Advisory Service Institute of Directors Hypothetical remedies Possible regulation of charges, terms, conditions or profits Possible behavioural remedies to reduce or remove the barriers to entry Possible behavioural remedies primarily to safeguard SMEs in their relationships with their banks A possible tax, licence fee or fund Structural remedies National Farmers Union The Forum of Private Business Transaction charges Collateral when borrowing Margin when borrowing Availability of credit The 2000 survey Comments on Issues Letter The monopoly situation Competition Relations with customers Possible remedies Finance & Leasing Association The Small Business Agency A former bank employee The possible complex monopolies Issues

8 Market definition Effectiveness of competition Profitability and prices Relationships between SMEs and clearing banks Possible remedies Individual small businesses

9 Introduction 8.1. This chapter summarizes the views of third parties. In addition to those third parties whose views are summarized below, we heard from a significant number of other banks and building societies. Many of these told us that they did not currently provide the reference services, as it was not their strategy to do so or the focus of their business was elsewhere: we have only included their views of any specific factors in the market which deterred them from providing the reference services. With regard to banks and building societies currently offering the reference services, we have included below only those who provided views on aspects of the market, but elsewhere in the report we have taken into account the statistical information provided to us on the scale of their activities. Regulatory authorities Bank of England 8.2. The BoE s interest in the financing for SMEs stemmed from its remit to promote the efficiency and effectiveness of the UK financial system. This meant monitoring and analysing the way in which the financial system supports the wider economy, including the SME sector. The BoE recognized the important contribution that SMEs made to the UK economy, not just in terms of economic impact accounting for over 50 per cent of employment and output but in their capacity for specialization and their ability to respond quickly to the needs of the marketplace In the early 1990s the BoE was asked by the then Chancellor of the Exchequer to examine whether banks were passing on benefits of base rate reductions to their small business customers. The BoE collected data from seven major banks then involved in lending to SMEs during the summer of 1991 and autumn The results showed that between June 1991 and November 1992, 70 per cent of customers had received at least the full reduction in base rates. Of the 30 per cent of accounts that saw margins widen, half had increased by less than 0.5 per cent. The average margin over base rate, weighted by debit balance, was less than 3 per cent, which seemed broadly in line with loan loss experience The BoE believed that during the recession of the early 1990s there was evidence of a breakdown in communication and trust between small firms and banks. The banks had large exposures to the small business sector and had made substantial losses as a result of the recession. This posed a financial and reputational threat to the banking sector, as well as exerting a destabilizing effect on small businesses. It also highlighted deficiencies in relationships and information sharing between banks and their small business customers. The BoE s work during the last nine years had focused on these issues, and had covered the whole range of finance available to SMEs, not merely bank finance Since 1992 the BoE had consulted regularly with the SME community, through SME representative organizations and the business contacts of its regional agents. The BoE had also maintained a dialogue with finance providers, academics and those with a policy interest in the area. In addition to regular liaison, the Governor hosted a seminar each year to bring together groups of interested parties, and the BoE produced an annual report: the eighth edition of which was published in SMEs were not a homogeneous group and their financing needs varied. The BoE had aimed to cover the SME population as a whole but had tended to focus primarily on smaller firms The availability of finance was often at least as compelling a consideration for small firms as its cost, with a number of factors affecting it. Smaller firms tended, during a recession, to be more vulnerable to the economic climate than their larger counterparts. Lenders might cut back on exposures beyond what was quantifiably justified by the risks involved. In the last recession excessive and indiscriminate lending in the late 1980s had led to problems between banks and small firms. As a result the major clearing banks had to make provisions of around 3 billion against this part of their loan book, although not all these provisions crystallized as losses The BoE believed that banks had now adopted more discerning lending policies and improved credit-scoring techniques as well as sophisticated systems that detected at an early stage when businesses were encountering trading difficulties. The overall quality of the banks loan books had improved sig- 4

10 nificantly, which was reflected in the decline in the level of provisions against small business lending. (The BoE believed that this suggested a reduced likelihood of a sudden reduction in the availability of credit or difficulties in relationships between banks and SMEs than was the case in the early 1990s.) 8.8. The BoE believed that small firms had a higher probability of ceasing to trade than large firms and lending to them was therefore likely to involve a greater degree of risk. Evidence based on VAT deregistrations showed that small business closures occurred throughout the economic cycle, with slightly less than half the businesses closing in their first three years irrespective of economic conditions. Banks often chose to take collateral in order to mitigate these risks. Studies showed that the availability of debt finance to small firms was affected by the size and value of the assets which could be taken as collateral. The Small Firms Loan Guarantee Scheme, set up in 1981, had been useful for small firms constrained by lack of collateral or with no track record The BoE felt that small businesses had traditionally relied on overdraft facilities to finance anything from working capital to long-term investment projects. There had since been an acknowledgement of the need for appropriate forms of finance, for example a recent marked shift towards term loans. A small business might require a package of finance, tailored to its individual requirements. This had resulted from SMEs switching to, for example, asset-based finance and substituting these forms of finance in circumstances in which they would have traditionally used bank finance The BoE had found that UK small firms were less dependent on external financing than in the late 1980s. Research by the ESRC Centre for Business Research in Cambridge had shown that only 39 per cent of small businesses sought external financing of any kind between 1997 and 1999, compared with 65 per cent in the 1987 to 1990 period. The proportion of external finance for small businesses accounted for by traditional bank borrowing had also declined, from 60 per cent in the 1987 to 1990 period to 48 per cent between 1995 and However, between 1997 and 1999 it had grown again to 61 per cent. Rejection rates were lower for bank finance between 1994 and 1995 than for the 1991 to 1993 period, suggesting that the reduction in the relative importance of bank finance in the mid-1990s was demand rather than supply driven. In the 1997 to 1999 period, when the relative importance of bank finance recovered, the Cambridge research rejection rates fell further to 10 per cent The characteristics of bank finance in the UK had changed considerably during the 1990s. Bank lending to the SME sector had started to increase again, having fallen consistently from 1992 to The ratio of overdrafts to term lending had fallen significantly since early 1992 (49:51) and stood at 32:68 in March This shift away from overdraft financing to committed funds with fixed repayment streams had reduced small firms vulnerability to the economic cycle. Small businesses had, since the mid-1990s, also gradually increased their use of fixed-rate loans. This trend was advantageous for many SMEs as fixed-rate loans provided them with greater certainty of expenditure streams, assisting business planning and enabling businesses to operate in a more assured financial environment The net bank indebtedness of the SME sector had continued to fall. This reflected the marked upward trend in deposits, which reached a record high of 41.2 billion in December The ratio of deposits to lending was 102 per cent in March 2001, compared with 56 per cent in December In addition to the changes in the structure of bank finance, UK small businesses now made greater use of non-bank forms of finance, such as factoring, leasing and, to a limited extent, equity. Factoring and invoice discounting provided businesses with access to finance against their outstanding invoices. These forms of finance were particularly appropriate for small growing firms and for exporters unable to draw on further overdraft facilities. Factoring and invoice discounting activity was highly concentrated in the UK, with 58 per cent of activity in 2000 accounted for by the top four firms, three of which were owned by UK clearing banks Since the last recession, the proportion of external finance to UK small businesses accounted for by leasing and hire purchase had grown significantly, to an extent replacing traditional bank finance and was greater than the EC average. Research had found that SMEs used leasing as a substitute for debt finance and that 50 per cent of SMEs used leasing amounting to 19 per cent of their total debt. UK banks, through their factoring and asset-based finance arms, accounted for a significant proportion of this market. 5

11 8.15. Venture capital, which played an important role in financing those growth-orientated firms that it supported, accounted for just 1 per cent of external finance for SMEs in the period 1997 to The UK also had a growing informal venture capital market, with business angels playing an increasingly important role in filling the gap between debt finance and formal venture capital. The business angel market was largely invisible, although research by Harrison and Mason estimated that the UK had approximately 18,000 business angels and that they annually invested in the region of 500 million. Participation by the banks in this market included sponsorship of the National Business Angel Networks and a number of investments alongside business angels The BoE had identified real improvements in the relationships between finance providers and their SME customers. Banks had learnt from the last recession the importance of training staff to deal with the particular needs of small businesses (particularly for credit) in an efficient and cost-effective way. Banks had since devoted substantial resources to increasing the awareness and skills of lending managers and staff at branch level, and many had introduced sectoral specialists. For their part, small firms had increasingly understood that finance providers would benefit from up-to-date financial information. This had enabled banks both to improve the quality of their loan books, and to develop better relationships with their SME customers The BoE cited evidence that banking transaction charges had fallen consistently since 1992, with many banks freezing their fee structure. However, small businesses still cited charges as one of the main driving forces behind bank switching. This could reflect the fact that charges appeared to be more rigorously enforced now than in the past. Research showed, however, that only 4 per cent of small businesses had changed their bank in the past year, rising to 15 per cent for the past five years. The BoE believed it was necessary to take account of the importance that SMEs placed on the quality of services and on building long-term relationships with their finance providers; banking services were not necessarily price sensitive partly because they accounted for a very small amount of SMEs total costs and lower costs elsewhere were often not a compelling enough reason for a small business owner to change bank. In general real improvements in the relationship between finance providers and their SME customers had been identified. Measures to increase transparency on bank charges would be a positive step for small firms. Concerns had also been expressed at the number of errors made by banks in assessing charges The latest data supplied to the BoE suggested that the mean margin over base rate for small business lending during the second half of 2000 was approximately 2.75 per cent. Margins had remained fairly stable over the past five years and prices reflected the risks involved in the SME lending market. The proportion of total bank income from small businesses attributable to fees and charges varied between the banks, ranging from just under 20 per cent to just over 40 per cent The BoE believed there was little evidence that SMEs currently had difficulty accessing debt finance from banks. Recent survey evidence reached the same conclusions New technology was increasing the range of facilities available in small business banking, for example telephone banking, which offered customers banking services outside normal working hours, and PC and Internet banking services. There was evidence that the take-up of PC and Internet banking was increasing This was an industry of very large set-up costs; to provide a full banking service to SMEs required, for example, volume, ability to spread risk, and need for a track record and reputation. A degree of concentration was not therefore surprising. However, there was scope for entry by cherry picking particular bits of the business, assisted by the diversification by small businesses in supply of finance; for example, a greater use of asset finance etc, at the expense of overdrafts traditionally supplied by the main banks. Hence the BoE believed that the small business banking market had not been devoid of new entrants. Abbey National and its subsidiary First National had both entered the market. Telephone and Internet banking reduced the need for extensive branch networks and should make entry to the small business banking market easier The BoE concluded that it found little evidence that SMEs had any real difficulty accessing debt and other forms of bank finance. 6

12 Hypothetical remedies Commenting on the hypothetical remedies, the BoE reiterated that, based on its contacts with the providers of finance to SMEs and the SME community, it considered that SMEs in recent years had faced little real difficulty in borrowing from banks or accessing other forms of bank finance; and, perhaps more significant in the present context, that relationships between banks and their SME customers had improved significantly since the early 1990s. Although the main focus of its work had been the provision of finance rather than the provision of banking services generally, it was nevertheless striking that it had heard relatively little from small firms or their representative bodies about the latter With that background in mind, the BoE was surprised by the CC s provisional conclusions and had serious misgivings about several of the hypothetical remedies The complex monopoly findings related primarily to the terms and conditions attached to small business current and deposit accounts and to money transmission services, rather than to the provision of loans and other debt finance to SMEs. This accorded with the BoE s own assessment that SMEs had full access to bank finance on broadly reasonable terms and conditions. In view of this, the BoE believed that the provisional conclusions that terms and conditions in the SME banking market were more restrictive than would emerge under fully competitive conditions, and that charges were unrelated to costs, needed further justification or qualification As for the hypothetical remedies, the first set involving possible regulation of charges, terms, conditions and profits seemed to envisage a significant element of control over banks commercial operations and relationships with their customers. The BoE had serious misgivings about such detailed intervention, which could damage rather than improve the provision of SME financing, which was its major concern, and deter entry. Rather than a requirement to pay a specified rate of interest on current accounts, such matters should be driven by market forces, as was the case with Halifax s and others recent moves to pay interest on current accounts in the personal market. This would possibly be assisted by transparency and encouraging SMEs to shop around, particularly those requiring a more basic banking service. If similar market developments occurred in the business market, it could reduce any crosssubsidy between deposits and loans; but the take-up of that development would then be a matter for choice by individual firms. The BoE believed that if payment of interest on current accounts led to a shift from deposit to current accounts, there would not be any significant effect on banks liquidity requirements or on the money markets. Any effects could be fairly small, because just over 60 per cent of SME deposits were already in no-notice accounts and the remainder accounted for only about 3 per cent of major British banking group sterling sight deposits and only about 2 per cent of sterling time deposits. Moreover, liquidity requirements were based not just on the formal legal terms of an account but had a very strong behavioural element The BoE had more sympathy with the remedies proposed to increase competition: to remove barriers to entry, improve transparency in the market and facilitate switching. On this last point, however, it had little evidence that banks had conspired to make switching more difficult: indeed, if anything, they appeared to be taking action to reduce the cost of switching and low switching might reflect SMEs satisfaction within their existing suppliers. Some of the remedies designed to safeguard SMEs in their relationship with banks seemed sensible, to the extent that they succeeded in improving transparency of pricing. Again, however, the banks were taking on board many of the remedies through their development of the proposed new Code of Conduct for Business Banking. The BoE was also not aware of any conclusive evidence that banks took excessive or unnecessary collateral in their SME lending; indeed, its analysis suggested that a greater proportion of banks lower-value lending to SMEs was now unsecured. It was also concerned that some of the remedies, for example a ban on discriminatory prices or on requirements that SMEs maintain a business account as a condition for a loan, could put at risk the relationships between banks and SMEs that were of benefit to both sides. Such relationships allowed the banks to monitor cash flow and better to assess credit and offer appropriate services: it was because of such relationships, rather than lack of competition, that many SMEs were reluctant to change supplier On a possible tax or licence fee on banks excess profits and divestment of branches or businesses in certain areas, neither would, in the BoE s view, improve the provision of finance to SMEs or encourage new entry into the market; if anything, they would both have the opposite effect Most of the hypothetical remedies seemed unlikely therefore to lead to greater competition or to facilitate new entry, as the CC itself appeared to recognize in some of its own comments. 7

13 Financial Services Authority The FSA gave us considerable background information concerning regulation of the banking sector. It also provided us with more specific information on regulatory capital requirements of different banks The FSA was able to provide us with composite information covering seven players with material loans to unincorporated businesses, and 28 potential players either with minimal SME lending at present and/or considered likely to be interested or have capacity to participate in the market. The players were estimated to account for some 92 per cent of current overall estimated SME lending and potential players some 7 per cent. The overall estimated SME lending, however, would currently amount to around 2 per cent of the 35 banks balance sheets. Although the players were generally the larger banks, there were several potential players of similar size In general terms, larger banks on average had lower regulatory capital ratios and smaller banks had higher ratios. This was largely explained by larger banks generally having more professional management; the capacity to invest in and maintain higher-quality systems and control risk management; and more diversified business and greater ability to withstand losses in parts of their business. The players, therefore, being on average larger institutions, had slightly lower regulatory ratios. However, potential players did not uniformly have higher ratios and the average for this group was only one percentage point higher. Moreover, both groups currently had actual capital ratios significantly above target: 3.9 percentage points for potential players compared with 2.5 percentage points for players. This extra margin suggested that having a higher regulatory ratio was not generally a business constraint, at least currently Finally, were the potential players to raise their lending to SMEs to a level equivalent to the average for players, their actual capital ratios would decline by less than one percentage point. This could be absorbed comfortably within their current margins of capital held above regulatory requirements. Banking Review Team At an early stage of the inquiry, we had a hearing with Mr Don Cruickshank and other members of the Banking Review Team (BRT). The clearing banks also provided us with copies of correspondence between themselves and the BRT As to the definition of SMEs, the BRT took those firms almost all limited liability firms, although a few individuals might be included which were no longer treated as personal customers by providers of money transmission services and credit. In other words, the firm had moved from its credit assessment being based on its history as a person, but too small to have direct access to competitive capital markets. There were about 1.3 million such businesses in the UK that were by and large a captive market for the clearing banks in terms of their access to money transmission and to a number of related services and debt in various forms. The 1.3 million approximates to firms with up to about 250 employees The 1.3 million would largely exclude sole traders and partnerships. The Treasury, Inland Revenue and HM Customs and Excise data about how many firms up to 250 employees paid or received VAT gave about 900,000 firms. The precise number did not matter because it was the characteristics of the relationship between provider and customer that were the concern in analysing competition The BRT said that such SMEs represented some 40 per cent of this country s private sector GDP. They were the source of much of the country s job creation and, increasingly, innovation: hence the importance of the CC s investigation. As in almost any other sector of the economy, those who ran or owned small businesses generally took the view that the clearing banks were all the same and had higherpriority things to do than worry about whether their charges for money transmission systems of one form or another could be reduced. They rarely gave active consideration to switching, as shown by the evidence of switching and what they said about the number of times they looked at alternatives. This was 8

14 a group of consumers subject to service by a limited number of organizations in a situation where there was huge information asymmetry between clearing banks and the individual small firm. Uncertainty about how the clearing bank would behave in uncertain circumstances in the future also had a significant effect on the relationship between banks and SMEs. This was a group that probably did not know that they were being badly served. Hence although surveys showed relatively high satisfaction with clearing banks, this was because customers were unaware of the improvements that could be provided There was no single indicator that suggested there was a problem. The BRT believed that the evidence of profitability and about pricing structures showed systematic cross-subsidy between money transmission services, that were the monopoly of the banks, and lending, which was not necessarily a banks monopoly, a cross-subsidy that distorted competition in both markets. By underpricing debt, the clearing banks made it less easy for pure debt providers to enter the market. There were other linkages between the banks central products, namely overdrafts and debt, and other sources of finance, such as factoring, where, not insignificantly perhaps, the banks also had very large market shares In Chapter 3 of its report, the BRT recommended that there should be systematic regulation of bank money transmission systems. The distortion of competition identified, which led to the recommendation of a payments system commission (PayCom), existed in extreme form in the provision of services to SMEs which were proportionately, by and large, much heavier consumers of money transmission systems than personal consumers. The issues surrounding money transmission were therefore also relevant to our inquiry Also relevant to our inquiry from Chapter 2 of the Cruickshank report were the economic barriers to entry to small business banking, which were higher than for personal or large corporate banks, given the difficulty in getting a banking licence on terms that were economic for people who might finance that bank. Smaller players, particularly those coming to the market, were required to hold higher levels of regulatory capital than those who were established, because, being new, they did not have a track record, and therefore the FSA found it difficult to assess how risky they were. That distinguished the UK sharply from the USA, although it was difficult to reach an independent view on whether the regulatory capital requirements were higher than appropriate. In the USA, quite a small firm could operate and reduce its cost base through outsourcing and other arrangements, and the greater degree of regulatory supervision in the USA, with regulators physically located in the banks, could be used to overcome some of the uncertainties of start-up companies. This did not apply in the UK The main reason, however, that small business banks developed in the USA was the application of structural rules at a local level as to broadly what market share any individual bank could have in small business lending, so that in the event of a merger there were quite often spin-offs of branches and customers There were some banks in the USA, therefore, which were single-branch, essentially business, banks, which lent only to businesses within half an hour s walk of the only branch. Some of those were new and were created usually as a result either of some form of merger or because a lending manager in an existing bank thought that he could do a better job than in his existing bank, so he created a new bank. The banking market in the USA seemed to have captured a means of generating local knowledge and aggregating it in ways which allowed new entry or change of ownership in the local market, together with access to economies of scale in a whole number of outsource functions, enabling them to operate with only one or two branches In the UK, on the other hand, all the new entrants over the last five years had been either in joint ventures with a bank, or a subsidiary of an insurance company which undertook deposit business analogous to a bank: suggesting that organization and procedures in the UK were very risk averse A number of obstacles also operated against the efficient outsourcing of the back office, which distinguished the UK from the USA and made it less easy for the small banks to access the economies of scale of cheque handling. One was the access of non-banks to the underlying money transmission system on what seemed to be unfair terms; the second was the fact that VAT might be charged on handling cheques by a non-bank but not by a bank, hence a 17.5 per cent penalty for subcontracting to a non-bank. On the first of these points, the BRT believed PayCom should establish broad rules of access to money transmission systems, ie that access should be on fair and reasonable and non-discriminatory terms, rather than needing detailed regulation. This would include use of branches of other banks. 9

15 Profitability There was evidence in the Cruickshank report of returns significantly higher than the cost of capital. Asked about the argument that surviving firms might be expected to have, on average, returns higher than the cost of capital because the ones that had lower return were not observed, the BRT said that there were very few banks which did not survive, in part because entry was so difficult and because of regulation In analysing profitability, the BRT had, for the purposes of the calculation, accepted all the banks assertions about regulatory capital that should be allocated to personal and small business banking, despite which there was systematic earning of supernormal profits in the personal and small business markets The BRT focused on return on equity since banks had unusual balance sheets, being highly geared, and their capacity to do business on the asset side, such as making loans, was crucially determined by their willingness to enter into typically short-term liabilities by taking deposits. These deposits were not analogous to an ordinary firm going into the debt market and issuing securities in a competitive marketplace, but represented in effect the banks working capital The operation of taking deposits and lending and having a spread of two and a half or three percentage points in doing so was akin to the production of a service or a product. It was that which generated a margin that, net of cost, generated a profit: the cost of deposits was effectively an operating expenditure. The BRT was aware of no other valid way of assessing the banks profitability On the time period over which rates of return should be considered, in the late 1980s a number of factors poor credit assessments, a determination to invest all the regulatory capital, plus a significant informal pressure from the Government to support the UK small business sector resulted in a loan portfolio which was not economically rational. Since the mid-1990s there had been effective professional management of risk assessment, effective quality control, and a rigorous focus on only investing in what was economic, and to the extent that that was less than regulatory capital, returning that capital to shareholders In estimating the excess profits of services to SMEs, the BRT said that the activities of the 11 firms in question in banking outside the UK and in activities outside banking were not the subject of the review, but by and large seemed to be competitive sectors, and there was no reason why, systematically, services such as insurance or international sovereign debt should be anything other than competitive. Within UK banking, corporate banking ie lending to large companies was also competitive. Logically, therefore, the source of the supernormal profits were the personal and small business banking markets in the UK which, even on the banks assumptions, the BRT assessed to be between 3 billion and 5 billion, of which services to SMEs accounted for between 0.5 billion and 1 billion. The main source of those excess profits was money transmission and deposits, not debt However, the BRT felt that the disaggregated information given to it of a return on equity for non-banking and non-uk activities at 30 per cent, given that some of those activities were reported to be loss-making and were in markets which one would expect to be much more competitive than banking, were subject to considerable error and almost certainly overstated. Allowing for that, the rate of return on UK banking would rise These figures included an efficiency adjustment. The BRT believed banks were probably technically quite efficient, but not very good at ensuring that the whole service was provided efficiently. The pace at which the UK banks were adapting to the opportunities of using new technologies, compared with Scandinavia and the USA, was definitely slower, in part because they had market power which enabled them to dictate the pace of that change because the possibility and the impact of new entry was muted. Hence, there was an efficiency gain to be delivered in the UK from a more competitive marketplace. The battle for NatWest during the period of the review showed the efficiency savings that were planned to be procured, and it was likely that a competitive market would deliver even more On the role of branches, the pattern of consumption of small companies was increasingly different from that of personal consumers. More and more personal consumers were prepared to deal on a distant basis, whereas many small businesses had a need for access, and physically close access, to money transmission for depositing cash and cheques. The cost of the physical presence to serve small businesses well would increasingly be borne by small businesses alone. 10

16 8.54. The banks were responding to that, with small business banking centres on the edge of industrial estates, not subject to high street rents. There was no cash held in those centres so these were much cheaper premises from which to conduct small business banking. Hence, the operation of banking services for small business was being distanced from the branch, except in the crucial area of money transmission and access to the capacity to deposit cash The clearing banks were not, however, moving as fast as they could because they correctly identified that it was not in their short-term and perhaps medium-term economic interests to change the pattern of consumption of small business. It suited the banks for these to be local markets which a limited number of banks had the capacity, the branch network and the skills to cover densely, secure in the knowledge that the small firm needed physical access to a branch of some form, in order to access the money transmission system, and secure in the knowledge that the information asymmetry, particularly for those small firms which wished to borrow money, was such that the small firm would want to be close to its bank manager. The market and competition The BRT had concluded that it should not include activities such as asset finance and factoring in the same market as the provision of overdraft and term debt. It told us that a firm engaged in asset finance, in assessing whether to lend to an organization, looked at least as much, if not more, towards the residual value of the asset in the second-hand market, whether it was at the end of the lease or in the event of insolvency of the firm, when the asset was retrieved by the asset finance company. Their pricing and attitude to whom they would contract was therefore materially influenced by their assessment of second-hand value of the asset and, to a much lesser extent, the creditworthiness of the firm or the individual. They were exercising a very different credit and financial analysis from that which a bank was making in extending overdraft facilities or a term loan Similarly with invoice discounting and factoring, in negotiating a discount at which an organization would take over the legal responsibility for pursuing and receiving the money for a package of invoices, that assessment was being made on the creditworthiness of the customers of the firm, not the firm In both cases, therefore, the basis of pricing of the form of debt was different, and the actual price would have very little influence on the price that the banks would charge for overdraft or term debt facilities to the same firm The trend towards the use of asset finance in particular was very pronounced and very strong. As SMEs became more sophisticated, it was gradually becoming established practice that, having established an equity base, a firm would then exhaust the possibilities for asset finance before moving to term loans and then perhaps overdraft facilities to deal with short-term fluctuations in cash flow Among the reasons why the BRT reached the view that the market was local was that almost all access to a local facility was essential for firms with a high volume of cash and cheque transactions. Half of businesses used the closest provider for their main source of finance. The median travel time between firms location and branch used for the money transmission was 8 minutes. Interestingly, firms were much more likely to be closer if their main source of finance was bank debt: the sense of the need to be close to the local bank manager was stronger the more a firm borrowed. 80 per cent of SMEs were less than 30 minutes travel time from the main provider of finance The main deficiency of potential entrants such as ex-building societies was that they did not have local information. The investment and the risks that they would have to take to build up a sufficiently dense and representative debt book in a local area was much more substantial than might initially be imagined Although the clearing banks averred that this was a national market because they exercised national or at least regional control over their lending decisions, the BRT s view was that although regional centres could veto a local manager s decision, the response to that was for the bank manager to enter into further discussion with the potential client and go back with another proposal. The banks claimed both that relationship banking was essential to perform well in this market, and that prices were set nationally. The transactional history was vital, ie having the money transmission business of the firm 11

17 in question to which no one other than the client s own bank had access. To ask for it and give it to another bank so that another bank could make an offer turned out to be difficult. There was also a link between money transmission and debt. If a small business chose its bank by the location of its money transmission, then it might automatically go to that same institution for lending because that was where it held its transaction account The BRT analysed pricing reasonably extensively but could come to no conclusions about whether there were local prices. Pricing of debt was difficult to analyse given the underlying risk assessment, which was difficult to factor out of pricing comparisons Almost all the banks marketing spend in the small business sector was aimed at the new startups, typically with free banking for two years. They spent hardly any money, time or energy in competing for the business of established firms. The BRT suggested that changes in market share of individual clearing banks reflected success in attracting start-ups, not competition for people switching accounts On whether reduction in price in real terms suggested some competitive pressures, this depended on the trend in the underlying cost base. There had also been a trend towards charging higher fees, although that was a genuine attempt to be more cost-reflective Among possible barriers to entry, particularly by ex-building societies, were brand and reputational factors. The requirements of a personal consumer market were also drawing the ex-building societies to high street sites not accessible by car and a particular mode of presentation to personal consumers which was going further away from the facilities required by many small businesses. They were recruiting managerial and counter staff who were not equipped and could not easily be trained to handle the small business market. Such organizations might be interested in lending were there not also the systematic cross-subsidy due to the capacity of the four main banks in England and Wales and the two in Scotland to overprice money transmission systems and to allocate a proportion of that surplus to creating an artificial and competitive barrier to entry in the provision of term debt. Moreover, because it was a local market the competitive response of the established players in local markets might cost so little as to make it uneconomic for potential entrants to enter any particular market A further entry problem was bundling on the demand side, ie customers using money transmission services thought they might need a loan at some future date, even if they did not need a loan then, hence they ought to take their money transmission services from an institution that was likely in the future to give a loan. This made it difficult for institutions that provided only money transmission services to enter the market. On the other hand, given the way in which the prices were structured, it was also difficult for an institution that only wanted to offer loans to enter the market. The same was also true on the deposit side with the added complication of how quickly money could be moved from a deposit account to a current account in the event that the current account started to run out of money. If it were the same institution, transfers could be done on the same day; but between different institutions, unless the customer was prepared to pay about 20 per transaction, it would take at least three days: a further bundling. Mono-line producers therefore found it difficult, either because of demand-side factors, or because the one thing they might provide on its own was underpriced It was in part because of the real economic barriers to entry to supplying services to SMEs that further intervention was required to give small businesses the same benefits expected to arise from new competition in personal banking As to the scope for new technology to increase competition, the money transmission services that could be conducted electronically were limited: cheques and cash, as the most significant methods of money transmission for the foreseeable future, still required physical access. Telephone and Internet banking were a means to ascertain balances and switch money between current and deposit accounts, but to run a deposit account at another institution required three days in the clearing cycle with problems for cash flow. Whether use of new technology would actually lead to the development of more effective competition within the market was therefore open to question. Without effective competition, the Internet and related technologies made it easier to exploit market power: there was not an automatic association between the deployment of new technology and more competitive markets It was similarly uncertain how lending decisions would be made over the Internet, which needed credit analysis of a firm s business, but without local knowledge the amount of information that was available was negligible. 12

18 Possible remedies Lying behind the BRT s view of possible remedies was the economic analysis that it was possible to be a profitable business bank on quite a small scale in a local or regional market. With relatively few branches in a city, with the capacity to outsource a back office to large-scale processors and get non-discriminatory prices from them, it would be possible to build quite quickly and economically, in terms of return on capital for equity investors, a business in which there was no economic imperative to expand elsewhere unless such an entrant wished to do so. That being the case, divestment of a viable local business to a third party was economically sensible or possible. Such structural remedies would not involve the physical dismemberment of buildings or teams of staff. That was a product of the more professional way the four largest groups had begun to run their small business banking over the last four or five years. They had made it possible for a structural solution to work at some, but not huge, inconvenience to the customers. US experience where businesses were divested showed that some customers quite liked the newcomer, and some of those who were being forcibly moved to the newcomer did not like that and moved on. This would be highly inconvenient for a few, but not necessarily inconvenient for the many. This was, crucially, not the structural dismemberment of a vertically integrated organization, because it had the underlying payment systems that could serve any combination. Such divestment would therefore be of a viable business unit (including relationship managers) which encompassed keeping in place local knowledge and relationships. These seemed rather dramatic measures, but the argument was that competition was so poor that some structural solutions were required, and evidence from the USA indicated that this was not nearly as difficult as would be argued and was at least a credible threat. In certain markets it might indeed be sufficient for the banks to sell branches to each other; in others it would not A further approach was an obligation on a bank with significant market power in a local market to provide money transmission on non-discriminatory terms to the customer of a new entrant. If that new entrant could satisfy the small firm s need for proximity to money transmission, it could offer better borrowing terms or other services, before establishing branches in the area: indeed in the USA, sometimes new entrants did not even bother to establish branches. Other banks Airdrie Savings Bank Airdrie Savings Bank said that it was the last independent savings bank in the UK. Its traditional business was providing a banking service to personal customers, but during the last ten years it had progressively developed services for some 200 small businesses, including current and deposit accounts, overdrafts, term loans, cash handling and access to foreign/electronic payments through its BoS connections. It operated only through its eight branches. Its small size and limited geographical coverage meant that while it could provide a personal and dedicated service within its territory its capacity for growth was limited, but more by its own constraints than by market issues. It had been able to develop by offering a different type of service to that offered by the major clearing banks in its area. Bank of Cyprus (London) Ltd Bank of Cyprus (London) Ltd (Bank of Cyprus) had prime banker relationships with some 3,000 SMEs throughout the UK, primarily owned and managed by Britons of Cypriot or Greek extraction. It regarded the UK SME market as overbanked and therefore intensely competitive. Any expansion out of its natural niche market could, although desirable, prove to be extremely difficult to secure profitably Bank of Cyprus said that one of the main difficulties in addressing a UK-wide SME portfolio outside its niche market would be that SMEs were cash hungry and that a UK-wide branch network was therefore a prerequisite. The UK clearing banks, uniquely perhaps in Europe, provided access to their network to competitor institutions on a commercial basis. Despite this, however, a major nationwide drive for business relying on such collaboration would introduce a further dimension of risk to such a venture. This was because it would entail reliance upon a competitor s network, both of tills and ATMs, and would mean that a large part of its transaction cost base was in effect in the hands of such 13

19 competitors. Naturally, prospective customers would expect to be charged a competitive fee for counter transactions, ATM transactions and money transmission charges, and Bank of Cyprus would, as at present, have to absorb the relevant agency fees. However, that was not to say that the large banks were in any way culpable. They had invested vast amounts of money to establish these networks and it was open to any competitor to replicate them. Bank of Cyprus said that it was unreasonable to expect the clearing banks to go very much further than they were in granting access to smaller institutions. It experienced no difficult in securing bids for its clearing account An alternative, which might be of universal benefit, would be for charges for the use of the clearing system per se, as opposed to charges for the use of an individual institution s counter network, to be subject to standard transaction costs irrespective of user. Crédit Lyonnais (UK) Crédit Lyonnais (UK) told us that it provided some banking services to SMEs in the UK. Its payment services were extremely modest, clearing being processed by a UK bank on its behalf. It did not generally provide lending to SMEs as a service in itself, its small lending book generally supporting other services that it provided in the UK or its international network. A modest amount of Treasury services were also provided to UK SMEs. On equity brokerage, corporate finance and mergers and acquisitions, it had a team dedicated to the small capitalization market, a subsidiary company of Crédit Lyonnais being a broker to between 30 and 40 small-capitalization companies. Among others, corporate finance advice was provided to these clients. The SME team was part of a pan-european unit reporting to Head Office in Paris, a limited amount of their activity involving UK SME. Crédit Lyonnais told us that during the late 1980s and early 1990s it had opened nine provisional branches aimed primarily at the mid-capitalization corporate sector; return from these branches was judged to be insufficient and they were closed during the mid-1990s. Halifax plc Halifax told us that it had not to date had any involvement with the SME sector. However, it envisaged that its new significant Internet banking operation, Intelligent Finance, would wish to provide banking services to the small business sector, and it was also considering how it might more widely enter the SME market On the Cruickshank report, Halifax concurred with many of the recommendations made, although it was not convinced that some of the matters identified in the report were against the interest of consumers. In particular, Halifax believed that the current payment infrastructure was open and effective, and that there was enormous competition in the marketplace, with the ability for new entrants to come in and relatively low barriers to entry. Halifax did not therefore fully understand how a separate payment infrastructure would achieve anything that the current infrastructure was incapable of doing On money transmission services, Halifax was a member of APACS and BACS and two special interest groups, but not of CCCC. It joined APACS and BACS in the mid-1980s, following the deregulation of the building societies, since as a big user of BACS it was in its interest to join and get a direct service. It had looked at the cost of joining CCCC and providing its own cheque-and credit-clearing facilities, but originally chose to clear through Barclays. It had reconsidered that decision a number of times but never concluded that there would be any significant advantage from disturbing the current arrangement. It had also put the agency arrangement to tender (out-clearing and in-clearing being tendered separately). Membership would give a voice at the table and Halifax stayed close to the debates on truncation and all the changes in cheque clearing; if it felt things were happening that were against its interest, that would increase its desire to be a member: but so far it had not found that to be in its interests, principally for financial reasons. The joining fee would previously have been about 800,000, since any new member required significant processing changes from existing members, and Halifax would have to have taken on the sort codes it currently had through an arrangement with Barclays (although it would not have expected to have to change that sort code). There would also be other significant changes to make to its own processing and costs, possibly in the order of 5 million to 10 million, although it was likely that third party processors would be used for part of the processing cycle at least. Such investment in infrastructure was undesirable given the decline in cheque usage and the overcapacity in the market. 14

20 8.81. Using an agency arrangement had no effect on service levels, including the time cycles for clearing a cheque, Halifax s time requirements being absolute and part of the tender. To change the basic 2.5-day cycle of clearing into a 24-hour cycle, without increasing the level of risk, would require a totally different infrastructure. On possible acceleration of clearing times, in particular the time to clear for fate (when a customer can withdraw the money credited to the account), Halifax noted that it would be possible to build a communication system that transmitted details of failed cheques on day 3 (currently a postal system was used which usually provided such details on day 4), but only at considerable cost Halifax noted that one possible restriction was that, because it was not a member of CCCC, it had to settle through a member with a BoE settlement account. This was not a problem if a member both processed and settled on an ongoing basis: but processing through a non-member would require a separate arrangement to settle. In practice, however, this was unlikely to prove a problem since banks that used third party processors were keen to recruit more volume to their processor, so themselves would be willing to provide settlement facilities On its attitude towards the SME market, Halifax told us that it had got involved in an aspect of SME business in the mid-1980s when the then Building Societies Act allowed lending to housing associations and builders, such loans still being secured. The scope for such lending increased further under 1986 legislation. The subsequent downturn after 1989 showed that Halifax lacked a branch infrastructure containing people who were experts in the risk diagnosis of business. Lending to SMEs would require a shift in focus from looking at asset value to factors such as ability to repay, including credit scoring: a different skill base for evaluating risk, particularly for unsecured lending or lending against equity, and with a further requirement to monitor accounts. After that earlier experience, development of an approach to small businesses, given that Halifax did not have the core competency, was not a priority. Currently, however, Halifax was of the view that increasingly there were ways to serve parts of that sector better than it was served at the moment, for example using new technology, or by focusing on SMEs with deposit rather than lending requirements, although it had not precluded a lending role. As of March 2001, however, Halifax had not recruited all the senior staff required to manage its expansion into the SME market, nor finalized the proposition it would offer On barriers to entry, Halifax did not believe that lending to SMEs required a business s current account, since it was possible to examine bank statements, although there was a natural relationship between overdraft facilities and current accounts. Deposits, however, were a free-standing area of business, and likely to become increasingly competitive. There was also not much to stop Halifax providing current accounts. In some cases banks charged little for transmission services, but paid little on deposit accounts to compensate. This created an opportunity to compete for deposit accounts, which Halifax intended to do: the limited entry into the market to date partly reflected the desire of businesses to maintain existing banking relationships and improve the likelihood of flexibility in that relationship if flexibility proved necessary. Most businesses also expected a single bank to provide a full range of services. The greatest barrier was on lending where particular skills were necessary, and would have to be acquired from within the established banking community, as would also be necessary to satisfy the FSA. While there might be scope to focus on particular sectors of business, Halifax saw little advantage in trying to enter on a local basis; unlike the US market, the UK had national payments systems. It saw no regulatory barriers to entry Halifax did not believe that its existing branch network put it in a position readily to enter the SME market. First, Halifax s branch network was used primarily for personal savers and depositors rather than current account activity and, with increasing use of the telephone, Internet and ATMs, the office network was likely to get smaller. Only the smallest businesses, in its view, would deliver cash to bank branches, larger businesses using carriers. But secondly, its local branches would not be to the advantage of any loan business, for which an area-type arrangement would be more useful. Branch networks were not therefore necessary for business banking, except possibly for very small businesses requiring nearby cash deposit facilities Halifax was aware that a very small proportion of its customers used their personal accounts for business purposes, although it was a condition of its current accounts that they were not used for business purposes. Business accounts required more scrutiny under money-laundering regulations: hence Halifax had identified some accounts as being used for business purposes (only about 0.25 per cent of all its accounts) and asked for the use of the accounts to be changed (although in some cases the account was allowed to be maintained, subject to a higher level of scrutiny). 15

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